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Only a diehard contrarian could be interested in natural gas with the near-month futures price down 74% from the 52-week high and a supply glut as far as the eye can see, some might say. Pure play, no-debt, no-hedge, buy-recommended Hugoton Royalty Trust (HGT) is down 71% from its high stock price and trades at 58% of its 200-day average in a sure indication of a downtrend, at least looking backwards. It is also trading up 52% from its low price and has 150% appreciation potential to a McDep Ratio of 1.0. With a little patience, investors can make money in the stock again, we believe.

Thumbnail of Natural Gas Industry Dynamics
On the upside, we have to work through the current surplus either with reduced supply or increased demand. Investment in new supply is drying up and will eventually be zero if price stays low. Without new supply, old supply declines. If it doesn’t decline enough this year, it will by next year or whatever it takes. On demand, we believe in economic growth. Economic growth requires energy. No new coal or nuclear plants are likely to be built in this country for a while.

Even if you are more optimistic on coal and nuclear, it will be very expensive and take a long time. Conventional oil has essentially peaked. Alternative energy is vastly overrated and in the end won’t be cheap or quick either. Looked at another way, alternative energy needs higher natural gas price more than natural gas does.

Much of the decline in industrial demand is inventory related. Once inventories are drawn down, chemical plants start running more again and use more natural gas.
LNG may be available cheap for the next few months, but the total amounts are small, like a few percent of world natural gas supply. Moreover, liquefaction plants are hugely expensive and no new ones will be built at today’s LNG price.

Storage of natural gas is a seasonal issue. Once storage is full in November, it doesn’t get fuller than full and the contribution storage can make to winter supply is finite. Then pricing depends on weather and domestic production as well as industrial activity. By next winter, domestic supply will likely be declining and can be increased again only after a time lag.

Meanwhile, new shale gas supply potential is indeed impressive. It is also given to exaggeration. To get the supply requires an equally massive drilling effort. Whenever we undertake large scale expansion of a new energy source as we did with nuclear power in the 1970s, oil sands in the 2000s, LNG in the 2000s, prices rise far above the early economics used to get the trend started. It is good to have a promising new supply source because that adds political justification for higher prices on existing supply.

Originally published on May 1, 2009

Source: Hugoton Royalty Trust: A Stock for the Natural Gas Contrarian