Why 2017 Is the Year to Invest in Gas Stocks

By Matthew DiLallo Markets Fool.com

Natural gas prices were red-hot last year, jumping 63%. That said, despite the recovery, gas prices were still at their lowest level in nearly two decades, averaging just $2.49 per million Btu for the year, though they did end 2016 more than a dollar higher. Weighing on gas prices were warmer-than-normal temperatures, which pushed residential and commercial gas demand down 7% and 4%, respectively, last year. Nevertheless, demand from other areas, including the power sector, as well as the export market,strengthened. These strengthening markets, combined with the return of more normal weather, could drive gas prices even higher in 2017, potentially making it a great year to invest in high-growth gas producers.

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The supply and demand story

Last year U.S. natural gas production declined by 1.3 billion cubic feet per day (Bcf/d) to an average of 77.5 Bcf/d, marking the first annual decrease in output since 2005. Driving down production was a sharp drop in the number of active gas-drilling rigs, which fell 19% year over year. That was mainly due to producers cutting back investment because of low gas prices at the start of the year. Also contributing to the decline was the reduction ofoil-focused drilling due to low oil prices, causing a drop in associated gas production.

However, while both production and demand from residential and commercial customers declined last year, demand elsewhere continued heating up. Natural gas overtook coal as the leading generator of electricity in the U.S. -- contributing 34% of the nation's output compared to 30% for coal -- which drove up gas demand to the power market from 26.3 Bcf/d in 2015 to 27.6 Bcf/d last year. Meanwhile, demand for gas outside the U.S. increased throughout the year so that the country became a net exporter in November for the first time since 1957. The bulk of that gas went south to Mexico, which accounted for 87% of U.S. gas exports. However, the start-up ofCheniere Energy's (NYSEMKT: LNG) Sabine Pass liquefaction terminal in Louisiana began opening up new markets for American gas.

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Natural gas exports should continue growing in 2017. One driver is new export pipelines to Mexico. For example, pipeline giant Energy Transfer Partners (NYSE: ETP) and its partners expect to complete the $1.3 billion Trans-Pecos and Comanche Trail pipelines early this year, which have the capacity to transport 2.5 Bcf/d of gas to Mexico. The Energy Transfer Partners project will connect gas supplies in the Permian Basin to the Mexican border, where it will interconnect with pipelines to take the gas farther south.

Meanwhile, Cheniere Energy has only just begun ramping up its gas export capacity. The company completed construction of its first two liquefaction trains in May and September of last year and started shipping test cargos from both facilities. Those exports should ramp up this year. Meanwhile, Cheniere has two more trains at Sabine Pass nearing completion. As production from these trains ramps up, it will pull more gas from the domestic market.

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Three gas stocks that could be big winners in 2017

Natural gas market fundamentals appear to be improving thanks to slipping production and strengthening demand. Those trends bode well for gas prices, which could continue increasing, especially if weather normalizes and drives a rebound in residential and commercial demand. While that rising tide would lift all gas producers, three that stand out from the crowd as having the best ability to capture the upside of an improving gas market areRange Resources (NYSE: RRC), Antero Resources (NYSE: AR), and Rice Energy (NYSE: RICE).

Range Resources made a big bet on natural gas exports last year after spending $4.2 billion to acquire Louisiana-focused gas producer Memorial Resource Development. As a result of that deal, Range Resources sees its gas production rising 33% to 35% this year; 11% to 13% of that growth will come via newly drilled wells. However, the company could accelerate growth this year if gas prices increase because it has ample liquidity to develop its large resource position in Louisiana and the Marcellus shale.

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Rice Energy also completed a game-changing acquisition last year, spending $2.7 billion to acquire Vantage Energy. The deal will increase Rice Energy's 2017 production by a remarkable 70% above last year's average. In fact, the company plans to deliver that growth while investing roughly half its capital expenditures budget on building well pads and drilling wells that it will turn into sales in 2018 and beyond. Given its strong balance sheet, the company could pull this production forward and grow even faster next year if gas pricesheat up.

Finally, Antero Resources plans to increase gas output by 20% to 25% this year, which puts it on a faster organic pace than the similarly sized Range Resources. Driving Antero's growth are its lucrative positions in the Marcellus and Utica shale, which can earn excellent rates of return at current gas prices. Given those returns, Antero could accelerate its growth rate this year if prices rise and it decides to pull production forward to capture the opportunity to earn even higher returns. Otherwise, the company is on a trajectory to grow gas production by 20% to 22% annually from 2018 to 2020 while living within cash flow at current prices, which shows just how lucrative its asset base is in the present market.

Investor takeaway

Natural gas demand should rise this year thanks in part to increasing gas exports. This improving gas market should push prices higher, which would be a boon for low-cost gas producers Range Resources, Rice Energy, and Antero Resources. All three expect to deliver robust production growth rates this year at current prices, which alone should drive their stocks higher. Meanwhile, there is the potential for even greater returns if gas prices continue to heat up.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.