NGAS Resources has been our favorite Natural Gas play for a while and we have patiently been waiting for a buy signal. That buy signal is now upon us.

NGAS Resources, Inc. is an independent exploration and production company focused on unconventional natural gas basins in the United States that support repeatable drilling opportunities, principally in the southern portion of the Appalachian Basin. The Company specializes in generating its own geological prospects in this region, where it has established expertise and recognition.


NGAS (market cap $191M) has posted impressive profit growth, increasing from $15 million in 2004 to nearly $23 million in 2005. This trend has continued into 2006, with NGAS increasing production revenue by 116%. In this quarter alone, NGAS drilled 79 gross wells or 19 (net). They have also been aggressively pursuing strategic acquisitions and were recognized by Fortune Magazine as one of the top 100 fastest-growing small businesses for the second consecutive year.

And to the seal the deal, NGAS is well-managed and unhedged (or do I repeat myself?) We like management that does not hedge. It sends an important message to investors - “we believe prices will continue to rise and we believe in our ability to capitalize on these advances. Furthermore, we are in this for the long run and you can count on us to make the best decisions for the future of the company.”

In my consulting experience, I was often frustrated by executives with a complete lack of long-term planning. They did not want to hear about what would be best for the company over the next 5-10 years, they wanted to know how they could put up some impressive growth figures next quarter, get their bonus, juice up their resume and move on to a higher paying job with another company. But maybe the system is set up to encourage exactly that. Anyway, NGAS management seems to understand how to grow a company and their unhedged position is just one indication of it. Another comforting indication is recent insider transactions. 8 different executive and board members acquired over 15,000 shares on March 29th, at around $8.10-$8.50.

NatGas

The most important consideration for our timing and issuing of a buy signal is the price action of natural gas itself. From December of 2005 to May of 2006, natural gas prices (per mmBtu) dropped sharply from $15 down to just $6. Recent price action saw a jump to $8.20, attributed mainly to the recent heatwave. The price has since retreated back under $7, but we think this is just a temporary pullback driven mostly by profit-taking. While some analysts may see this jump as a temporary reaction to the high temperatures, we believe prices have considerable room to run and this quick spike is just a proverbial kick in the donkey’s ass.

Nat Gas v Oil

Another compelling reason to be long natural gas is the recent divergence with crude oil. Dividing the oil price by 6, gives you a trend line that has consistently tracked the price of natural gas. However, the two trend lines have recently diverged, as oil has continued to rise and natural gas took a sharp downturn. These two lines should come together once again and we are betting that it will be due to a rise in natural gas prices, as opposed to drop in oil prices.

Investments in natural gas futures and equities are not for the faint of heart. It is the most volatile of all commodities. But we foresee much higher prices between now and Novemeber, as demand grows and oil prices remain high. In the short-term, if significant hurricane activity materializes and prices follow similar movements to last year, we could see prices over $12 in a hurry.

With the leverage offered by NGAS Resources, a movement above $12 in natural gas prices could easily move NGAS stock up 40-50% from current prices. Even without hurricane pressure, we think NGAS will find strong support around $8 (10% decline from the close today of $8.90) and likely push above $10.50. This is especially true for the short-term, as natural gas is going into its high season.

NGAS Chart

So with upside potential for a 50% gain and downside risk around 10%, we really like the prospects.

You may want to wait for Q2 results: NGAS will be releasing its second quarter 2006 financial results after the market close on Tuesday, August 8, 2006. Management will host a conference call on the same day at 4:30 p.m. (Eastern). But despite low natural gas prices, we expect relatively strong results. We bought in today and price action seemed to confirm that others are expecting good earnings - up 2.5% today and up another 1.1% in after-hours trading.

Action: We purchased shares at $8.60 today.