This Natural Gas Play May Be Overheated

Just as new drilling technologies have created a boom in natural gas supply, so, too, has that boom borne renewed investor interest in the industry.

Prices have dropped to decade lows, and it seems that new market opportunities are springing up with every new well built. Some analysts have advocated investing in the actual commodity because of rock-bottom prices, or in large producers that are creating that growing supply. Still, others believe a "picks-and-shovels" approach is best, thereby taking advantage of the increasing demand for drilling equipment.

One company that has caught the eye of many industry observers is Westport Innovations (Nasdaq: WPRT  ) , a Canadian outfit that designs natural gas engines. As prices of that commodity have fallen, Westport shares have taken off.

Westport Innovations Stock Chart

Westport Innovations Stock Chart by YCharts

Not only have Westport shares more than tripled their worth in the past two years, but investors have also remained bullish on the stock, giving it a four-star rating in our CAPS community. Despite its bright prospects, however, the company's lack of profitability and price-to-sales ratio of 10.7 have led others to believe the stock is overvalued, leading to a significant number of shares sold short.

With convincing arguments on both sides of the debate, let's take a closer look at what's powering this engine-maker of tomorrow.

Under the hood
Westport has three major divisions: heavy-duty (HD), light-duty (LD), and a 50/50 joint venture with Cummins (NYSE: CMI  ) , known as CWI. Of the three, the JV with Cummins does the heavy lifting, as it is the only one that's profitable. In its most recent quarter, CWI made up more than 60% of Westport's revenue, contributing $49.2 million out of a total of $81 million. Its light-duty segment, which recently signed a deal with Ford (NYSE: F  ) to supply its F-250 and F-350 pickup trucks with Westport's WiNG Power System, tripled its revenue from a year before to $25.7 million. Westport HD, on the other hand, has lagged behind, contributing just $5.3 million in sales for the quarter, and gross profit for that segment was negative, with a loss of $1.3 million.

While Westport's top-line growth of 80% may be reassuring to shareholders, its lack of profitability in its independent sectors is not. The company's net loss for the quarter expanded from $6.2 million to $13.2 million. Investors may want to question when this 17-year-old company will finally reach consistent profitability.

The big picture
For Westport bulls, the argument is clear. Natural gas has become cheap and abundant and offers a cleaner alternative to gasoline.

A mass conversion to natural gas-fueled vehicles cannot happen overnight, however, no matter how much T. Boone Pickens-led Clean Energy Fuels (Nasdaq: CLNE  ) may want it to. Pickens' company is the leading builder of natural gas fueling stations in the United States, but with just 257 natural gas fueling stations out of about 1,100 across the country, Clean Energy Fuels is a long way from matching the ubiquity of the approximately 116,000 gasoline stations nationwide. Like Westport, Clean Energy Fuels has not made a profit.

The enthusiasm for natural gas vehicles seems to have gotten ahead of the capacity. Honda recently announced that it will distribute its 2012 natural-gas Civic in 36 states, up from just four the year before. But despite casting a wider net for its NG vehicle, Honda is producing only 2,000 of them, and it's still the only major carmaker selling a natural gas car in the United States.

International markets
Westport has gained attention domestically because of low natural gas prices, but it's also making waves abroad. International revenue has been growing faster than in its home base, as the Americas' share of sales dropped from 65% to 59% in Q2 2011.

Westport owns a 35% stake in its joint venture with Weichai Power, WWI, which recorded $29.9 million in revenue in its most recent quarter on growth of 126%. In China, however, natural gas prices are rising as the government is testing a program to let prices float instead of keeping them artificially low to promote manufacturing. Prices in China are already more than $2 per MMBTU higher than in the United States, where they've fallen to less than $3 per MMBTU. In Europe, the January 2012 price was $11.45 per MMBTU and in Japan $16.25 per MMBTU, several times more expensive than in the United States. The higher prices internationally mean a dramatic shift to natural gas fuel is unlikely.

Foolish final thoughts
The momentum fueling Westport's rise has come from a cheap supply of natural gas, but many producers believe current prices are unsustainable. Progress Energy Resources just last week joined a list of companies including Chesapeake Energy and ConocoPhillips in cutting its gas production. From a long-term perspective, the natural gas glut should lead to U.S. exports, and Cheniere Energy (AMEX: LNG  ) looks to have the country's first export terminal by 2015. American exports of natural gas will inevitably move the worldwide market closer to equilibrium, therefore raising prices at home.

Given these assumptions, the time horizon for Westport to take advantage of seems relatively slim. Domestic natural gas prices should either go up in the near future as producers curtail output or around 2015, when exports begin. For a company that is not currently making a profit and seems at least a year away from developing the scale to do so, the expectations on the stock seem to weigh pretty heavily. Risk-seeking investors may like a company like Westport with high upside potential and strong momentum behind it, but for those afraid of the fallout from an increase in natural gas prices, Cummins looks like a better bet. Buying shares in that company will give investors exposure to natural gas engines through its independent projects and joint ventures with companies in India and China in addition to Westport, and it also offers the security and stability of a company that's been around since 1919.

Whether you're a believer in Westport or Cummins, I recommend learning more about another energy stock that's poised to benefit from the natural gas production boom. It's a drilling-equipment manufacturer with a 60% market share, and you can read all out about in this new special free report: "The Only Energy Stock You'll Ever Need." Get your free copy.

Fool contributor Jeremy Bowman holds no positions in the above companies. The Motley Fool owns shares of Ford. Motley Fool newsletter services have recommended buying shares of Ford, Westport Innovations, Cummins, and Chesapeake Energy and creating a synthetic long position in Ford. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 18, 2012, at 8:13 PM, Cyherbst wrote:

    I agree that natural gas prices will go up, but so are oil prices. Many analyst are spectating that prices at the pump will be rising very soon. As for exporting natural gas I think will be a grave mistake for the U.S. Government if they allow that to happen. I hope they tax the exportation of natural gas until it is unprofitable to do so. As an American I hope the conversion to natural gas succeeds for as a result there will be almost no dependency on foreign oil. I think even skeptics like you will be happy with at. Although many people seem to think so the leaders of our government our not idiots, I think we will soon see the day when the government formally backs the nat gas movement because of what it means for the U.S. Economy.

  • Report this Comment On February 18, 2012, at 8:36 PM, Rollomc wrote:

    As capatilists it would seem likley that NG providers would sell their product everywhere there is a market. The thing I like is that it competes with oil perhaps bringing the price down for all energy.

  • Report this Comment On February 18, 2012, at 10:03 PM, nancydog wrote:

    A quick reference to Malthus would make one hesitate to see any optimism regarding any fuel source which is non-sustainable. Most of the world's population has yet to partake of the need for personal transportation, infinite desire for electricity, and other uses for oil, gas, NG, and other such. Eventually as demand overtakes supply because of the Malthusian dilemma, we will have to turn to sustainable energy supplies. I understand the short term value of energy investments, however, for those of us who are trying to leave both personal assets, and a better world for our grandchildren, and succeeding generations, we must look to develop infrastructures of the future. I do not see view, at all, within the financial community.

  • Report this Comment On February 18, 2012, at 10:07 PM, nancydog wrote:

    *

    A quick reference to Malthus would make one hesitate to see any optimism regarding any fuel source which is non-sustainable. Most of the world's population has yet to partake of the need for personal transportation, infinite desire for electricity, and other uses for oil, gas, NG, and other such. Eventually as demand overtakes supply because of the Malthusian dilemma, we will have to turn to sustainable energy supplies. I understand the short term value of energy investments, however, for those of us who are trying to leave both personal assets, and a better world for our grandchildren, and succeeding generations, we must look to develop infrastructures of the future. I do not see this view, held as a priority, within the financial community, or Congress. I am not a Green Peacenick, but just an 80 year old grandfather who would like to see some progress in the right direction, during my lifetime.

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  • Report this Comment On February 18, 2012, at 11:06 PM, Cyherbst wrote:

    @ nancydog

    Recent studies have show that the U.S. contains a enough natural gas to sustain it's self for roughly a 100 years. I agree with that in the really long run we will have to turn to sustainable energy, but the sad truth is that the technology simply does not exist. A lot can happen within a hundred years time why would we stay with rising gasoline when nat gas is a fraction of the price. With the money the economy saves on nat gas we may further invest on the exploration of a sustainable resource. Before we can even speak of a sustain able resource as Americans we must cut this addiction to foreign oil.

  • Report this Comment On February 19, 2012, at 12:24 AM, Hueyones wrote:

    Yes, domestic oil and nat gas will eventually run out, but it probably won't be for at least 100 years. In the meantime, energy companies are competing to design and bring alternative energies to the forefront. Those alternative energies will make it to the forefront when/as they become economically competitive. There is no reason for Federal subsidies and loans, which have turned in to nothing more than a giant slush fund to reward political cronies. Energy companies will get the job done without Federal involvement.

  • Report this Comment On February 19, 2012, at 8:35 AM, iswhatitis wrote:

    This summer Gas prices will go over $4 and the rush for alternatives will boom. The bird in the hand is Nat Gas. It's a spec, but, what are the alternatives?

  • Report this Comment On February 20, 2012, at 11:07 AM, popgoestheweasel wrote:

    David Gardner says WPRT is the stock pick for the NAT GAS play.Reading Jeremy Bowmans article the stock is shorted and overbought or as he put it "overheated" I'm confused!

  • Report this Comment On February 21, 2012, at 10:16 AM, pelucidar wrote:

    @popgoestheweasel You are on the same page as I am. I guess either way Motley fool wins huh? Doesn't do much for me as a paying subscriber. I can do that with my wife all day. I think this is a great stock and she says I don't think this is a great stock.

  • Report this Comment On February 21, 2012, at 3:11 PM, vinnybernese wrote:

    popgoestheweasel, I suppose to be fair one should note that Fool was recommending WPRT back when it was down in the $20's or perhaps even lower. This latest article is far more recent, although MF has re-posted the WPRT recommendation many times in between. So it seems maybe now is the time to take profits (of around 2x) and move on, if you got in back in those days (maybe over a year ago).

  • Report this Comment On February 26, 2012, at 12:00 AM, itsy1958 wrote:

    I agree, pop & vinny...seems MF is touting WPRT one week & the next saying it's had its run. Wish they would make up their minds! I just received an email this week once again saying this could be a "10 bagger". I thought about getting in at 22 (wish I had), finally bought @28.17 and sold at around $40 with about a 33% gain. Pondering on whether to get back in or not, but am also confused & not too keen on a company that has never made a profit (yet). I do own CMI & will probably buy more of that company when it goes down again (as all stocks are wont to do). Would be nice to know when Congress is going to vote on the NatGas Act...

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