Some company will eventually make a killing from today’s collapse in natural gas prices.

But when? And which company?

Value investors usually only need to identify a bargain and then hang on until the rest of the stock market catches up with their thinking. But the plunge in natural gas prices has been so severe and could last so long that some of the companies with the best natural gas assets may not survive the shakeout.

Balance sheets are at this moment more important than geology.

Prices are the beginning of the problem. Benchmark Henry Hub natural gas for September delivery closed at $3.163 per million BTUs (British thermal units) on August 17,

That’s a 44% decline in price since the beginning of 2009 and the lowest price since September 2002.

And traders fear that this isn’t the end of the worst. 

Natural gas in storage climbed 63 billion cubic feet in the week that ended on August 7. That pushed inventory to 592 billion cubic feet higher in that week than they were in the same week a year ago.

The problem is supply and demand.

 U.S. natural gas producers continue to increase supply with much of the new gas coming from land-based wells from what were once called ”unconventional” sources such as the gas shales of Texas, Utah, and Wyoming. Natural gas production was up almost 2% in the first five months of 2009 compared to the same period in 2008, according to the U.S. Department of Energy.

That increase in supply has come as demand has crumbled. Consumption fell by 4.2% in the first five months of 2009. Factories, chemical plants, and steel mills account for 29% of U.S. consumption. With the recession many of those customers are running at less than full speed. Demand from industrial customers fell 13% in the first five months of the year.

The worst of the crunch is still ahead. (For another way to judge when the oil and gas sector has bottomed see my post “Next week it’s oil, oil, and more oil earnings” https://jubakpicks.com/2009/07/24/next-week-its-oil-oil-and-more-oil-earnings-to-know-where-the-industry-is-going-forget-profits-and-look-at-capital-spending/ on using capital budgets as a leading indicator.)

 Natural gas producers with big debt loads and high interest payments haven’t yet cut production. In the second quarter companies such as Chesapeake Energy (CHK) have used higher production to beat Wall Street earnings projections.

And companies that had the smarts or good luck to lock in higher prices with hedges haven’t cut production either. XTO Energy (XTO), Devon Energy (DVN), and Ultra Petroleum (UPL), all companies with hedges that cover a good portion of their production reported either an increase in production or big profits from their hedges or both. XTO, for example, reported that it had received an average price of $7.08 per million BTUs in the second quarter thanks to its hedging activities.

But both of those alternatives look like they’re running out of gas. All that production has to go into storage in the absence of customers. But storage space isn’t infinite and the system is approaching its limits. That, of course, will drive Henry Hub prices for future delivery even lower.

Hedges—and the profits they protect or generate—expire and the cost of new hedges has been climbing as prices have been falling. That’s if hedges are going to be available at all. As a result of Congressional efforts to crack down on energy speculators, regulators such as the Commodity Futures Trading Commission, have floated proposals that would either restrict the number of hedges available or increase their costs.

Normally, I say the best way to profit from the collapse in natural gas prices would be to buy shares in the companies with the biggest reserves and just wait, and wait, and wait for natural gas prices to rebound.

Two problems with that in these abnormal times.

First, natural gas stocks have massively rebounded from the panic lows of late 2008 when investors feared that many producers would go bust because their balance sheets were so loaded up with debt.

Chesapeake Energy, for example, traded at $11.32 on December 1, 2008. It closed say $22.25 on August 17, 2009.

It’s easy to understand December’s panic. Chesapeake showed $13.2 billion in long-term debt at the end of the fourth quarter and analysts were predicting the collapse of the company’s cash flow. The fear was that the company would have to liquidate a major part of its asset base to stay liquid.

It turned out that analyst projections were absolutely accurate. Cash flow from operations did fall from $5.2 billion in the fourth quarter to $1.3 billion in the first quarter of the year.

But the company was able to raise more cash from selling off assets than analysts thought, which meant that Chesapeake had to sell off fewer assets. The company got close to top of the market prices from BP (BP), for example for some of its gas shale assets. And Chesapeake Energy was able to strike ingenious deals to raise cash. For example, the company got an accelerated payment for drilling costs from Plains Exploration and Production (PXP) of $1.1 billion by offering a 12% discount for early payment.

And the company’s hedges came through big time. In the second quarter of 2009, Chesapeake saw gains of $597 million from hedging. With hedging its realized price of natural gas in the quarter was $5.56 per million BTUs. Without hedging, the realized price in the quarter would have been $2.68 per million BTUs.

All of which leaves a value investor with a tough decision to make.

Are Chesapeake, and other natural gas producers, bargains at current prices because they’ve survived the worst of the crisis? Which would make them bargains at recent prices.

Or are these stocks headed back to something like the panic prices of December when investors realize that the worst isn’t over but it yet to come?

I think you know where I come out. I think natural gas prices are going to be lower in a few months than they are now. I think hedges are going to be more expensive (and contribute less to profits) and companies are going to have hedged a smaller percentage of production in 2010 than in 2009. And I think we’re finally going to see a drop in production from some producers as storage space gets increasingly tight. I simply don’t see the size of increase in capped wells that I’d expect at the bottom.

And that will mark the bottom for this cycle. I’d expect to see that bottom sometime in the next three to 12 months. Sorry I can’t be any more specific but so much depends on when the economic recovery arrives and how strong it is when it does knock on our doors.

That said, I don’t expect prices at this bottom to each quite the depths of the end of 2008 panic. We should be able to see a recovery by then—even if it won’t have done much of anything yet for natural gas prices. For a rule of thumb investors might see a retracement of about 40% to 60% of the gains from the lows. For a stock such as Chesapeake Energy that would mean a price of $14 to $18 a share.

And we should be able to see that given slow action on global climate change natural gas will be a key, if not “the” key, transitional fuel as the world tries to reduce its use of oil and coal, both of which add more CO2 to the atmosphere when burned than natural gas does.

I’d recommend a two-fold strategy to value investors in natural gas.

 First, I think you can buy shares of the natural gas producers with the best balance sheets right now. These stocks won’t show a huge drop if I’m right about a bottom in the next 12 months. And if I’m wrong, you’ve own a piece of the sector at a decent price. My two favorites here are Devon Energy and Ultra Petroleum.

And second, you can wait to buy the more leveraged companies in the sector, such as Chesapeake Energy, at a bottom. Waiting will give you a better read on exactly how many of the assets you’re paying for will remain with the company.

I’ll be looking to add a stock or two from the first group sometime this fall when I feel I have a better read on the direction of the market as a whole.

(Full disclosure: I own shares of Devon Energy and Ultra Petroleum in my personal portfolio.)