Over the past year the spot price for natural gas is down 38%. The plunge has taken most natural gas stocks down with it with the stock prices of WPX Energy Inc (NYSE:WPX)SM Energy Co (NYSE:SM), and Eagle Rock Energy Partners, L.P. (NASDAQ:EROC) in particular, really taking a beating as we can see in the chart below.

Henry Hub Natural Gas Spot Price Chart

Henry Hub Natural Gas Spot Price data by YCharts

Given that more than half of their production comes from natural gas and natural gas liquids, or NGLs, these stocks are getting hammered due to weak natural gas prices as well as a bleak outlook for future prices. That said, the drubbing these three have taken is deeper than most of their peers. In fact, according to S&P Capital IQ data these three companies have the lowest enterprise value-to-EBITDA ratios among natural gas producers suggesting that they are the most undervalued natural gas stocks in the sector.

A look at the numbers
While there are many ways to value a company, the Enterprise Value-to-EBITDA, or EV/EBITDA, looks at a more complete picture of a company's value as it takes into account its debt. Further, it helps to reduce some of the distortion of taxes and one-time charges that can impact a company's earnings and therefore produce a Price-to-Earnings ratio, or P/E ratio, that's artificially higher or lower than it really should be. 

According to S&P Caital IQ, Eagle Rock Energy Partners has the lowest EV/EBITDA at 2.5 times among natural gas stocks and its followed by SM Energy's at 2.8 times and WPX Energy's at 3.0 times. Those ratio's are very undervalued against the average EV/EBITDA ratio of exploration and production companies, which is 5.1 times. 

Why are these natural gas stocks undervalued?
Aside from the fact that these companies produce a lot of natural gas, one recurring theme as to why these companies are undervalued is due to the fact each is in the middle of a long-term business shift, which isn't being fully realized by investors. Both SM Energy and WPX Energy are actually shifting away from natural gas production and into oil and NGLs. Meanwhile, Eagle Rock Energy Partners shifted its business away from a combination of operating upstream and midstream assets to a pure-play upstream MLP and even more recently announced it was merging with another upstream MLP.

While these shifts are designed to create value, the market has yet to recognize the progress these companies are making. For example, SM Energy, which currently produces 46% natural gas, 23% NGLs and 31% oil is moving decidedly toward oil and NGL production. Over the past year its oil production is up 43% while NGL volumes are up 35% and gas production is roughly flat. That said, while the increase in oil and NGL volumes are boosting the company's EBITDA, investors still see a natural gas company, which is why they're not bidding up its market value. 

WPX Energy is in a similar boat. Natural gas is still 70% of its overall production while oil is currently 20% of its production and NGLs are 10%. However, over the past year its natural gas production has fallen by 11% while oil is up 80% and NGL production is down 4%. While the additional oil production is driving stronger EBITDA, it's not driving a stronger market value just yet. 

Finally, we have Eagle Rock Energy Partners, which currently produces 53% natural gas, 21% oil and 26% NGLs. The main reason it's so undervalued is due to the fact that it has undergone a major business model shift over the past year. The company jettisoned its midstream assets to focus solely on oil and gas production. One of the reasons it made that shift was due to the fact that it couldn't handle its debt load while continuing to pay a steady distribution to unitholders due to the variability within its cash flow. Those past problems have kept the company chronically undervalued. More recently it sought to unlock that value by merging with another upstream MLP and while that deal came at a 24% premium to its undervalued unit price, so far units remain undervalued as the current unit price is still 20% lower than the offer price as investors worry that the deal might not close. 

Investor takeaway
Heavy natural gas producers SM Energy, WPX Energy, and Eagle Rock Energy Partners are all wildly undervalued when we look at their EV/EBITDA ratio and compare it to other oil and gas producers. A big reason why these three are so undervalued is because investors don't seem to see the changes they are making to create long-term value. It's what makes them the great undervalued natural gas stocks to buy right now.

 

Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.