5 Reasons Natural Gas Is Poised to Bounce Back

Every once in a while, commodity prices fall so low, they can’t be produced cost effectively anymore. Inevitably, producers have to eliminate production and scale back or drop expansion projects to reduce supply. Inevitably, the commodity’s price comes climbing back.

It happens all the time. It happened when uranium fell to $7 a pound nearly a decade ago. It happened when oil fell to $10 a barrel a few years ago. It happened again to oil a few months ago when prices fell to $35 a barrel. It’s happened to zinc, copper, agriculture – every commodity.

It’s how the commodity world works. Booms and busts. The most profitable way to invest in commodities is to buy during the busts and wait for the booms. The profits can be magnificent.

Right now, one commodity is going through a “mini-bust.”

The price of it has fallen 75% in the past few months. A slew of reports about declining near-term demand and rising stockpiles have sent the price of it down even lower. Near-term prospects are grim, but it’s looking like a buy.

I’m talking about natural gas.

Mainstream Turning Down the Gas

Now, if you look at a few recent headlines, it’s easy to see natural gas is out of favor.

• Bloomberg: “Gas Decline Signals ‘Meltdown’ Toward $3.”

• International Business Times: “Natural Gas: A Victim of Its Own Success.”

• Forbes: “[Department of Energy] Says Natural Gas Supplies Rise Unexpectedly”

There’s no denying natural gas has fallen out of favor. The bearish sentiment has only gotten stronger in the past few days. It’s getting ugly out there for natural gas. Traders who were holding out for a recovery are quickly throwing in the towel as prices continue to fall.

As with most out of favor, beaten down commodities, every time the price of natural gas drops though, I get even more interested. Here are five reasons why I’ve slowly started to buy natural gas.

1. Near-Term Outlook is Bleak – Over a year ago, Seth Klarman said:

“Most investors tend to project near-term trends—both favorable and adverse—indefinitely into the future.”

He’s dead right. Most investors fail to look beyond this next week- even though, in most cases, their time horizon is much longer. They’re doing it again in natural gas right now.

That’s why natural gas prices are so low right now. Natural gas is very expensive to burn. It’s more expensive than coal and nuclear as an electricity source. As a result, natural gas fired turbines are only used to meet marginal electricity demand. Normally, they’re only running during peak hours of the day when factories are humming, offices are open, and, in the summertime, when air conditioners are turned way up.

We can see evidence of this in the volatile swings for natural gas prices. When marginal demand is high, natural gas prices are very high. When marginal demand is low, natural gas prices fall very low.

Right now marginal demand is low. Factories are shutting down, businesses are shutting down, and thermostats (in buildings with electric heat) are getting turned down to help cut expenses. That’s why natural gas prices are so low relative to their recent highs.

As usual, Wall Street is projecting this near-term trend long into the future.

2. Supply is Getting Cut – When demand falls, prices fall. When prices fall, supply falls. It’s a basic rule of economics. Right now, the rules are hitting natural gas.

The number of natural gas rigs have been slashed nearly in half. Less than a year ago there were 1,600 natural gas rigs pumping out natural gas in the U.S. That was at the peak of the energy bubble though. Now there are less than 900 rigs in operation.

That’s not all though. There’s also something else unique to natural gas. The Dallas Fort Worth Star-Telegram reports:

“In the view of most producers, the sharply lower drilling will translate into declining production by year’s end. Natural gas wells typically experience a decline of at least 50 percent from their initial production in their first year, with lesser declines for several years before flattening.”

The combination of reduced number of rigs and reduced output from each rig will lead to a sharp reduction in supply. As we’ve seen in every commodity cycle for the past 100 years, low supplies eventually lead to higher prices.

3. Oil to Natural Gas Ratio – Oil and natural gas have always been closely related. It’s rare to find oil in the ground without natural gas. And vice versa.

Although the prices of both don’t move in lockstep with each other, they do have a relationship. The best way to look at it is with energy equivalency.

In energy equivalent terms, a barrel of oil produces the same amount of energy as a six Mcf of natural gas. So in dollar terms, this works out to a pretty wide cost disparity. The cost of a barrel of oil’s worth of energy from oil is $50. The cost of the same amount of energy from natural gas is only $22.2 (6 times $3.7 per Mcf).

There has always been some disparity in these prices because oil is so much easier to transport around the world and natural gas is usually limited to the continent it’s produced by (excluding liquefied natural gas). The ratio rarely gets so far out of whack though. On an energy equivalent basis, oil rarely costs more than twice as much as natural gas.

History shows, when oil prices rise, natural gas prices follow (in broad terms – there is very little relationship in the week to week volatility of oil and natural gas prices).

4. Inflation – Inflation is coming, eventually. The Fed’s number one priority has been to stave off deflation. Even though deflation is a natural consequence of a massive credit contraction, the Fed has proven its willingness to pull out all the stops to bring inflation back (and we haven’t even witnessed the most drastic actions yet).

Eventually, this will lead to inflation. Whether it’s hyper inflation, mild inflation, or anything in between, it doesn’t really matter. The Fed wants inflation and it will do anything to ensure it happens.

Of course, there will be consequences. One of those will be the nominal price (the price tag price) of real assets will go up. There are many ways to protect and actually increase your wealth during periods of inflation.

One of the best way is to own real assets. Most investors tend to focus on precious metals like oil, gold and silver as a hedge against inflation. Don’t get me wrong, there is a place for these in your portfolio. However, there are many other hard assets to own. Among my favorites are farmland, bridges, roads, and, at current price levels, natural gas.

5. Cap and Trade – As we discussed earlier this week, the installation of a cap and trade scheme is practically a lock. The current president is a masterful campaigner. Now he’s campaigning for the cap and trade legislation as part of his administration’s budget proposal.

Natural gas will be a clear benefactor of the cap and trade legislation because it is produces significantly less carbon than coal, America’s leading source of electricity. Natural gas-fired turbines produce 70% less carbon than brown coal and only about half as much carbon as coal-fired turbines.

In an era where carbon will add significantly to the cost of high carbon energy sources, the environmental friendliness of natural gas will make it an even more economical alternative to coal.

As you can see, there are quite a few reasons to start getting bullish on natural gas. These five are just the start though. There are a lot more.

For instance, the U.S. Department of Energy predicts 900 of the next 1000 power plants will be natural gas fired (and that was before the cap and trade system was even on the table). China recently publicly renewed its commitment to building electricity production capacity from sources other than coal. A few major corporations and government agencies have announced purchase commitments for tens of thousands of new natural gas fueled cars and trucks.

We could go on and on, but you get the point. Natural gas prices won’t stay this low for long. The natural gas boom will return. It always does.

In the end, we’re probably a bit early here. Natural gas prices have fallen 10% in the past two days and stockpiles are sitting at six-year highs. Frankly, the odds of a sharp rebound are slim, but a rebound will come.

As a result, I recommend taking action accordingly. There is a great opportunity to write covered calls against a position in natural gas ETF like United States Natural Gas (UNG). Or you can start building a “starter stake,” which would allow you to dollar cost average, in a leveraged ETF like Horizon’s Betapro Natural Gas Bull Fund (TSX:HNU).

Finally, natural gas prices have been setting extreme lows. Last week natural gas prices fell to their lowest levels in six years. That means natural gas offers lower risk and greater reward than it has in the past six years.

Comments

[basehitz:]

I have made many of the same arguments myself. I sold a large UNG position last week. At best, dead money barring some unforeseen near tern catalyst. More likely, a hurricane season play or next winter. I don't disagree with any of your arguments except the timing.

I do have one new argument. The CNBC cheerleaders just last week near 50d ma starting pumping NG both Fast Money and BooYah man. Since I assume they are pumping on behalf of Da Boyz at the expense of their viewers, I am cautious on anything they recommend.

Mar 30 10:43 AM

[Mad Hedge F...:]

This is the screaming buy out there in the energy sector. Natural gas ($NATGAS), which peaked at $13.50/btu last year, has become the red headed step child of the energy complex, plunging a gut churning 72% to a low of $3.75. To see demand this weak coming out of a cold winter is nothing less than stunning. The credit crisis has forced US companies like Chesapeake Energy (CHK) and Devon Energy (DVN) to scale back exploration, so the US rig count had dropped by half. The price collapse is welcome news for consumers, as NG is an essential raw material for making naphtha, fertilizer, and plastics and accounts for 20% of US electric power generation. It also is a favored fuel of the green crowd, as the only products of its combustion are carbon dioxide and water. The industry was making the leap from a domestic industry to a global one just the global recession punched it right between the eyes. The completion of six liquefaction plans in Qatar, Russia, Indonesia, and Yemen costing $48 billion is expected to boost global production by 25% this year, and more big plants are coming on stream in the near future. If I’m right, and those really are crocuses out there and not some florid hallucination, then it’s time to load the boat with NG.

Mar 30 12:27 PM

[BrotherMaynard:]

Im guessing this piece refers to the US nat gas situation as the structural realities there are very different from other geographies.

Either way, this article is exceedingly vague, and is filled with platitudes that were once famous during the energy boom-bust of the last 6 or so years...it is this sort of faulty reasoning that has since lost lots of money for lots of people.

To quote article:

re: pts 1 and 2: "Most investors fail to look beyond this next week- even though, in most cases, their time horizon is much longer. They’re doing it again in natural gas right now...that’s why natural gas prices are so low right now."

and then the author totally contradicts himself with his next point

" When demand falls, prices fall. When prices fall, supply falls. It’s a basic rule of economics. Right now, the rules are hitting natural gas."

Well which is it? Is it investors or supply/demand moving prices? Both? Are you getting equities mixed up with commodities?

Equities suffer from extrapolation bias that klarman refers to, given that they are the present value of future earnings. But a commodity is the present value of...well...its spot price. There are no future cash flows in a commodity. Again, extrapolation bias does not even apply to natrual gas much less any other commodity. Now it applies to natural gas-driven equities. But if we're talking about risking hard-earned capital on an idea, don't you think we should at the very least get the most basic characteristics of the vehicle correct?

re: pt 3: "It’s rare to find oil in the ground without natural gas. And vice versa"

This seems to be one of those vague assertions backed with no data.

US natural gas production from shale has spiked (see here: tonto.eia.doe.gov/dnav...) while US crude prodution has flatlined (see here: tonto.eia.doe.gov/dnav...).

"History shows, when oil prices rise, natural gas prices follow "

Obviously no data to back this one either.

So the most recent example shows that the "btu relationship" certainly didn't hold on the way down. Last Oct Nat gas was $8 and crude was still hovering around $100. There was plenty of talk rife with the notion about how nat gas would appreciate back to 12-13 right quick and close the "btu gap."

Obviously that's not what happened. Oil tanked in half from $100, thus following nat gas' lead on the way down. So what's to say nat gas at 3.75 isn't pre-saging $25 oil?

The point is, there is a lack of wide-spread infrastructure that allows switching between nat gas and oil (in the US) to create any sort of correlation that which investors can have any conviction in...so why get fancy when you clearly don't have the tools? Just use GDP as the common denominator.

Again, the narrowing of the crude/ng gap is an awful reason to risk capital.

"There are many ways to protect and actually increase your wealth during periods of inflation...One of the best way is to own real assets."

Based upon the authors reasoning for investing in commodities, thus far, it would be more wise to stick to TIPS as an inflation hedge.

"Natural gas will be a clear benefactor of the cap and trade legislation"

So invoking klarman's quote again...what's to say this isn't the extrapolation of the current administrations' leanings into a permanent change in the future of the US' energy consumption mix? What if obama is gone in the next 4 years, and we just get a slow and measured approach to energy consumption change? What if it costs too much? The point is, to assume that cap and trade is in the bag is absolutely ludicrous. It is this sort of presumptuous banter that will put you at more risk than you otherwise should be.


two questions that the author might want to consider:

What are the effects of LNG on the future of the US nat gas complex?

Does the falling margins of energy service companies, and thus, the falling cost for E&P's have anything to do with E&P's future profitability and/or incentive to drill?

Mar 30 04:57 PM

[kd2000:]

The main point here there is no real shortage of natural gas or is it ? Reducing supply and then increasing supply on need will only cause a temporary jump in price!! Basically if you don't time and sell the commodity, it will drop back again when supply meets demand again! The last jumps and spikes were because three reasons
1. Easy money supply, and
2. Artificially inflated prices because of lot of money chasing commodities in general.
3. Stupid fear that we are running out of OIL, so gas and coal are next best resources. There never was real shortage of OIL either. Refiners just did not want to refine. High OIL price was a bubble in itself. Even at $50 it is a mini rebound bubble.

I see neither of those conditions in next 5 to 10 years. This economy was leveraged several trillions of dollars! who thinks here that kind of binge spending is coming back again.

Mar 30 09:13 PM

[User 305589:]

The best way to buy natgas is to buy companies that drill the stuff with the lowest costs and a proven exploration and drilling team. the covered calls may work - but the risk is they will cut you out of the really big profits at some point.
Seciónd, the author completely fails to mention the HUGE supply of LNG that inevitably hits the markets this year and next. with the vbast storage capacities in the us and the recent strength of the greenback, it is attractive to many overseas producers to sell the stuff in the us. certainly more attractive than not to sell anything and go bk quickly.
i am bullish longterm on natgas, but 2009 and 2010 could be really difficult.
I have found that CHK's CEO usually in the cc has very good takes on the natgas market - and they are right about 80-90% of the time. which is why CHK has hedged a major part of its production for 2009 and 2010.

Mar 31 07:03 AM

[mc2406:]

I agree, kd2000 that there will always be oil (if you are willing to pay enough for it-- immense amounts of oil shale in Colorado and Canada, for instance). Same for natural gas-- its always been demand driven-- price was low forever (and supply limited by lack of drilling) until demand was (artificially or not ) deemed to be so high in the last few years).

Unfortunately, natural gas doesn't have the additional limiting factor of refining capacity to prop up its price as well. Oil has to be a better long term play, and natural gas may be low for a long time.


On Mar 30 09:13 PM kd2000 wrote:

> The main point here there is no real shortage of natural gas or is
> it ? Reducing supply and then increasing supply on need will only
> cause a temporary jump in price!! Basically if you don't time and
> sell the commodity, it will drop back again when supply meets demand
> again! The last jumps and spikes were because three reasons
> 1. Easy money supply, and
> 2. Artificially inflated prices because of lot of money chasing commodities
> in general.
> 3. Stupid fear that we are running out of OIL, so gas and coal are
> next best resources. There never was real shortage of OIL either.
> Refiners just did not want to refine. High OIL price was a bubble
> in itself. Even at $50 it is a mini rebound bubble.
>
> I see neither of those conditions in next 5 to 10 years. This economy
> was leveraged several trillions of dollars! who thinks here that
> kind of binge spending is coming back again.
>
>

Mar 31 09:43 AM

[toobad41:]

I just want to make a few points about oil and natural gas. Gas is found at almost any depth but oil is not. In other words oil is mostly found above 10,000 feet and if the bottom hole temperature is below 110 degrees F. If the reservoir is below 10,000 feet and the bottom hole temperature is above 110 degrees F you probably won't find any oil. Higher temperatures, formation pressures tend to crack the hydrocarbon leaving just gas to be recovered.
Where oil can be stored in almost any container on the surface or underground this is not easily done with natural gas. Natural gas can be stored in old abandoned fields unground if there is no leakage. But for the most part wells are shut-in and drilling wells are put off until the market for gas improves. There are some oil wells that produce gas along with the oil (casinghead gas) but that is something that is dealt with at the wellhead. It can be vented to the atmosphere, put in a gas line, or used to run the surface equipment, etc. One of the problems I see with natural gas is not mentioned in your summary is that there will be a large influence of importation of LNG in the coming years. I don't know the value of that gas nor the quantity of it. But it could be significant.

Mar 31 10:00 AM

[BrotherMaynard:]

toobad41...thanks for the details. very helpful.

despite all the rigs that are being laid down, it sounds like lots of wells are being finished and capped...after all, drillers pay for those rigs, they might as well use them. so i can't imagine it takes more than a few months to get those wells fired up once demand rebounds. starting from zero is one thing, but having 90% of the work done is another.

Mar 31 11:11 AM

[Mike T:]

Who wants to bet that the first mention of "Gulf hurricane" will double the UNG? Anyone?

Mar 31 04:23 PM

[toobad41:]

BrotherMaynard...
I don't know if you are aware of this but drillers are independent from exploration and producing companies. There are some exceptions but very few. For instance a company such as Conoco-Phillips may want to drill say 50 wells in a given area. They will ask for bids from various drilling companies to drill those 50 wells. Usually the lowest bid will get the job. Then the COP representives will meet with the winning drilling company and see when the rigs are available (and how many). Then they formulate a schedule as to when to start drilling and when the drilling will end. For the majority of exploration and producing companies they like to begin drilling in January and February. Most of the expenditure (budgeted moneys) for drilling is usually but not always completed by the end of summer. So to make a long story short....there is not much drilling in the second half of the year. The last three months or so of any given year is dedicated to formulating drilling plans for the following year. Drilling companies would love to drill every day of the year but that seldom happens. Rigs are laid down and rough-necks are let go.

Mar 31 05:08 PM

[Old Trader:]

Brother Maynard,

You make some good points, but I'd like to take exception to at least a couple of them.

"US natural gas production from shale has spiked (see here: tonto.eia.doe.gov/dnav... while US crude prodution has flatlined (see here: tonto.eia.doe.gov/dnav...

Gas (and oil) derived from fracturing oil is fairly costly process, and at current prices for both commodities, these projects are being shut down, or put on "hold", if they were new ventures. Secondly, there seem to be some enviromental concerns about the fracturing process, so given the Green "bent" of the current administration, there might well be additional raodblocks ahead on this particular road.


"What are the effects of LNG on the future of the US nat gas complex?"

This point has some validity on a global basis (markets outside of the US), but little here in this country. There are, I believe, 5 facilities that handle LNG in the US. New projects that were scheduled have been canceled due to the combination low prices and the tight debt markets. Additionally, the NIMBY syndrome is at work here, in the US. I will concede, however, its possible that facilities MIGHT be constructed in Mexico, and the output could be fed into the existing pipeline network here (which might be a big assumption, given that Mexico has its own energy issues, and might nit be willing to "share").

Mar 31 07:34 PM

[elliot_mllr:]

Further to the pint made by Old Trader, last year everyone looked for a major influx of LNG at the few existing terminals and those under construction, but, lo and behold, the influx did not happen. It turns out that Europe and Asia were willing to pay higher prices than those that were available in the US, and LNG tankers were re-directed to other destinations while en route to the US.

Apr 01 02:21 PM

[Mark Anthony:]

Absolutely agree. I recently bought UNG aggressively, in the price range between $15.00 to $15.20. UNG is now at least 50% cheaper than USO, from an energy point of view.

The ultimate new energy source had been announced by American Chemical Society last Monday. This will be one of the greatest science break through in the 21st century. You must read about it:
stockology.blogspot.co...

Back to UNG I do not think there is any further room for downside. Producers are already aggressively cut back.

Apr 02 01:19 PM

[user 385544:]

To your point, shipping costs last year vs. today's are at play...no? Day rates have plummeted and the ships are in over supply. So much so, banks find it profitable to lease ships and store crude (which could be another conversation all together im sure). Dry ships for example once getting 200k+ per day are more like 1k and/or cost of fuel!

opinions appreciated.


On Apr 01 02:21 PM elliot_mllr wrote:

> Further to the pint made by Old Trader, last year everyone looked
> for a major influx of LNG at the few existing terminals and those
> under construction, but, lo and behold, the influx did not happen.
> It turns out that Europe and Asia were willing to pay higher prices
> than those that were available in the US, and LNG tankers were re-directed
> to other destinations while en route to the US.

Apr 05 11:27 AM

[jarco:]

But, it costs more just to transport LNG to the US as NG sells at the market $4/Mcf. The only affects of mid-east NG will be competition to Russia


On Mar 30 12:27 PM Mad Hedge Fund Trader wrote:

> This is the screaming buy out there in the energy sector. Natural
> gas ($NATGAS), which peaked at $13.50/btu last year, has become the
> red headed step child of the energy complex, plunging a gut churning
> 72% to a low of $3.75. To see demand this weak coming out of a cold
> winter is nothing less than stunning. The credit crisis has forced
> US companies like Chesapeake Energy (seekingalpha.com/symbo...)
> and Devon Energy (seekingalpha.com/symbo...) to scale back
> exploration, so the US rig count had dropped by half. The price collapse
> is welcome news for consumers, as NG is an essential raw material
> for making naphtha, fertilizer, and plastics and accounts for 20%
> of US electric power generation. It also is a favored fuel of the
> green crowd, as the only products of its combustion are carbon dioxide
> and water. The industry was making the leap from a domestic industry
> to a global one just the global recession punched it right between
> the eyes. The completion of six liquefaction plans in Qatar, Russia,
> Indonesia, and Yemen costing $48 billion is expected to boost global
> production by 25% this year, and more big plants are coming on stream
> in the near future. If I’m right, and those really are crocuses out
> there and not some florid hallucination, then it’s time to load the
> boat with NG.

Apr 07 09:37 PM