Why I've Waited to Buy Natural Gas

Many people have written asking why The Kelly Letter hasn't bought natural gas via UNG yet. The following June 21 article (sent to subscribers), re-displayed here in its entirety, explains why. The addendum at the bottom shows what's happened since we ran the article.

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We've spent a lot of time looking at oil this year, and have put money on both the long and short sides of the fluctuating price. We're currently betting on lower prices ahead, and I still think we'll get them in the short term.

A related commodity that we've discussed much less is natural gas. In some ways, it's a better place to invest than the oil market. Let's look at those ways.

Natural gas is primarily a U.S. domestic commodity, much less exposed to the seemingly endless variety of pressures the world economy puts on oil. That, combined with limited storage capacity, makes natural gas less appealing than oil to speculators.

Because of that, natural gas prices have badly lagged oil prices in the recent move higher. A good many analysts attribute the spring oil spike as much to speculation as anything, and a glance at the fundamentals of the market lends credence to their view. The missing speculative element has left natural gas prices far below oil prices and, more importantly, historically cheap when compared to oil prices.

One way that's discussed is via the oil/natural gas ratio. Over the years, it has averaged about 8, which is to say that the price per unit of oil is usually about eight times more than the price per same unit of natural gas. Currently, that ratio is more than double, at 17. Something will give. Either oil prices will fall, natural gas prices will rise, or both. I'm guessing both. We already have money on the falling oil theme. Is it worth putting money on the rising natural gas theme as well?

There are plenty of reasons to expect the price of natural gas to rise. For one, at its current $4, it's not profitable to hunt down and develop new sources of it. That will constrict supply, which contributes to a rising price. Also, there's no equivalent of OPEC in the natural gas market. Overseas sources have a hard time competing because natural gas must be turned into liquid natural gas, LNG, to be shipped. Converting, storing, shipping, storing, and regasifying LNG is expensive, and nobody's going to jump on it at $4 prices. So, the supply picture is looking tight and suggesting higher prices.

What about demand? It's pretty strong. The Department of Energy projects that demand from both Canada and Mexico will grow in the coming years, and that Canada's unconventional production pace will not match that of the U.S. Currently, the U.S. imports about 16% of supply, and that's expected to decline to 3% in 2030. America's growing technology and unconventional reserves will give it an edge in the market, and allow it to become a gas exporter to meet rising demand.

World liquefaction capacity is growing, so that will support demand in other markets.

Focus for a moment on the source of natural gas in the future. As with oil, natural gas reserves are getting more complicated and scarcer. The more difficult and scarcer the supply becomes, the more expensive it becomes. That's another catalyst for higher prices.

Now, having told you all that, I need to pull the rug out from under you by mentioning that all of the above factors are applicable in the longer term. In the short term, I find that supply is brimming and demand is weak. That's the reason natural gas prices are low.

It's not hard to see why. Look at the recent economic figures we've received. Factories aren't exactly humming these days. Just last week, we saw another report showing that capacity utilization is still falling. The economy doesn't need as much natural gas in slow times, and these are slow times. That's why supplies are currently near peak levels.

There are two ETFs for betting on a rising natural gas price. One is UNG, which is run by the same shop that runs USO for oil, and is a vehicle based on the price of natural gas directly. An indirect approach is also available via FCG, a fund that owns the stocks of companies that derive significant revenue from exploring and producing natural gas. They're listed on the ISE-REVERE Natural Gas Index. Like the Dow, it has 30 components including Apache (APA), Chevron (CVX), Quicksilver Resources (KWK), Noble Energy (NBL), Shell (RDS.A), and Questar (STR). As you can see by the inclusion of Chevron and Shell, it's hardly a natural gas pure play.

Both UNG and USO, targeting the price of natural gas and oil respectively, peaked in July 2008. UNG kept falling all the way to the end of last month, but USO bottomed out in February. From its mid-February price of $23, USO has gained 65%. Since mid-February, UNG has lost 14%, and that's after a 17% pop in the last three weeks. The divergence between the two is obvious.

FCG peaked in June 2008, and bottomed in March. Since its March bottom, it has gained 59%. How much of that is from the excitement over oil and its potential to boost profits at the companies on the index is hard to say, but it's safe to assume a lot.

Many people have written to me about buying UNG, so many that it prompted me to check the popularity of the ETF. In two words: red hot. Its assets under management were only $700 million at the end of March. They hit $2.2 billion at the end of May and surpassed $4.5 billion just last week. More than $2 billion found its way into the fund in the first half of this month alone. That's 2.9 times the fund's entire asset base in March, proving that a stadium full of investors has concluded that natural gas prices are due for a bounce.

I don't see it yet. Current storage levels are more than 20% above their five-year average, and recently discovered fields in Louisiana and Texas sport solid production rates. The industry needs prices to fall, but individual companies can't slow production because they need cash now and will sell even at low prices. Less money coming in has cut the rig count back, and that's one reason people are looking for a price spike eventually.

As with oil, the time frame is critical. In the long term, almost every commodity will be higher in price, a conclusion you can reach by looking at nothing more than population trends and technology proliferation maps. More people demanding any finite resource will send the price of that resource rising, and that's nowhere clearer than in energy markets.

Fine, but in the short term, anything goes and right now what's going on is a stockpiling of natural gas reserves that will be able to absorb quite a bit of demand.

As we often do, we'll watch. The price to watch is Henry Hub spot, which closed Friday at $4.05 per million Btu, down from $6.10 on Jan. 6 but up from $3.19 on Apr. 27. How did UNG track during those time frames? Let's compare:

1/6 to 4/27
-48% Henry Hub spot
-47% UNG

4/27 to 6/19
+27% Henry Hub spot
+16% UNG

Recent choppiness has kept UNG from keeping up, and if natural gas remains weak through the summer, it will get cheaper again because it tracks well to the downside. It closed Friday at $15.16. My initial buy price target is $14.

Addendum
Since that article ran on June 21, UNG has dropped from the previous Friday's close at $15.16 to Monday's intraday at about $12.50. The factors mentioned above still apply, so we're watching and waiting for the right cheap entry.

Notice that we did not buy as soon as it hit the target price of $14. We often watch and wait for long periods before placing an active order, and this is one of those times.

Comments

[basehitz:]

Thanks. A realistic assessment, especially in contrast to many posts in recent weeks that sounded more like marketing pieces on behalf of the traders who prematurely bet long. I frequently challenged their logic. And my call has been for the 52 wk low to fail on heavy volume (which happened yesterday), and then for a washout. It would be ideal if a stock correction prompts a USD rally (temporary) which will spark selling in commodities. If oil is dragged lower, NG is expected to follow. That could be an excellent buying opportunity for the energy complex including NG. The long term macro picture for NG is favorable cause the US just doesn't have that many energy options on a commercial scale near term.

Jul 07 07:18 AM

[skrangeo:]

nice work. I've been railing on the other seekingalpha article authors for their factless, sunshine pumping articles on UNG without any regard to fundamentals (read: storage/supply/demand). Some have mentioned political tensions in Iran as a natural gas spike catalyst (LOL...Iran!)...others have mentioned the 18-1 ratio (without considering the underlying reason of WHY it has diverged...the emergence of the shale plays!). it's nice to see someone stepping back and not getting caught up in the "herd" mentality.

I work in the oil/gas business and have made two strong trades in UNG puts (buying the puts and selling them for a profit as UNG has droppped, one for a 100% gain and then selling yesterday for a 65% gain). All of the information is there for the public to see (lower demand, excess storage, supply that has held in great even considering the 55% drop in rig count) yet they've continued to pump UNG.

It's going to take the next 60-120 days before natural gas bottoms out. Their is already more gas in storage in the producing region than at last year's peak (2nd week of November). Henry Hub prices could get crushed in the upcoming months as the producing region storage maxes out (read: physical limitations on injecting storage gas) and the spot price is driven down. It is going to take situations like this to force companies to curtail production (because right now, they are still producing even at lower prices so that they can get the cashflow to service their debt levels so that they don't break their debt covenants). Once production is curtailed, the supply overhand will work itself off and only then will there be a bullish sentiment for natural gas.

I'm a long term bull but short term bear.

Jul 07 09:06 AM

[EX-AD-MAN:]

Thanks for this article, Jason. Anyone care to share ideas for dividend payers in the NG arena? I have been buying some Can Roys lately, currently shopping US MLPs. It would seem we are at least in bottom territory, and riding out the choppiness with some income seems prudent. Anxious to hear your thinking...

Jul 07 10:39 AM

[Steve Ward:]

Gas maybe down for the long term as well. Wood McKenzie cites 25 trillion cubic feet a year over capacity being built in Asia. True, the projects maybe cancelled but so many are half way done or nearing completion by the end of 2010.

Exxon cites that its 3 new trains comming on line will be able to make a profit with only $3.00 gas, that includes transportation. The profits come out of Exxon stripping higher profit NGL's from the raw gas stream.
USA now faces a possible dependency on imported natural gas. Particularly, if the Obama admin gets involved with the water issues involving shale gas.

Jul 07 10:56 AM

[GMiki1:]

I bought some UNG yesterday at $12.58. If it goes down, I'll buy a little more. I'm not a short-term trader. I made a little money in DXO--double up oil--selling when it topped out. I think oil will go down for a while and then rise again. I wonder what the CFTC hearings will do. I wish they would address the gold and silver shorts, but probably not.

Jul 07 11:46 AM

[tuj:]

"USA now faces a possible dependency on imported natural gas."

Nope. That's what people thought when they built all the regas terminals until shale came along. Politics aren't going to stop shale in any significant way; its perfectly reasonable to require the drillers to contain their dirty frac-water and to not cause mini-earthquakes. Otherwise people have been relatively receptive to drilling, even in Dallas suburbs.

Jul 07 11:55 AM

[Mad Hedge F...:]

Keep waiting. ) You may recall my advice to abandon natural gas at $4.30 in the face of giant new discoveries in shale formations (see “Cash out here at $4.30 www.madhedgefundtrader... and “Huge Discoveries at www.madhedgefundtrader... ). Since then, the Midwest has suffered its wettest spring since 1871. It rained 25 inches in Chicago the first half of the year, drowning golf courses, and sending the mosquito population exploding to Biblical plague proportions. Let me assure you, I have absolutely no ability to predict the weather, except that my combat scars itch when a storm is coming. Cold weather means no air conditioning, which means cratering natural gas demand and a new two month low of $3.37. But when you see a parallel contract like crude soar to new heights, and NG fail a half dozen times to get off a five year low, you know rough weather is coming. The crude/gas ratio players really got carried out in body bags on this one, as one record after another was shattered, taking it to a stunning 19.4:1. Best to wait for natural gas to find its new, lower range before entertaining a position.

Jul 07 12:16 PM

[skrangeo:]

UNG trading halted today!

Jul 07 02:23 PM

[BPYHO:]

I hear everyone congratulating this guy (and it is a good article). However, where was this article a month ago when everyone and their mom was shoving Nat gas down our throats!? Talking about ratios, other Nat gas plays besides UNG to avoid contango, ect.... Publishing this article now doesn't do the suckers (Im one of them) any good, it would have been nice if you (or seeking alpha) published an article like this one earlier.

Jul 08 06:36 AM

[H. T. Love:]

There was information and articles out there. Unfortunately, it takes some time, which I know is not available to all, to ferret out the data. I had started my first attempt at sharing about this back on June 4(?) but wasn't able to get it completed until the 28th.

One of the things (of many) that I've learned since finding SA, is don't wait for the articles. Identify posters that comment or publish that have active blogs on SA, add them to your "following" list and go check their blogs frequently.

You'll often see an article before it gets published, be able to ask questions and sometimes get answers, etc., before the article is published.

You will also get a separate e-mail when one you are following publishes an article. This acts as a back-up in case you missed a blog post.

This has been *very* helpful for my learning curve. Folks like, Feya
seekingalpha.com/user/...

post on a range of subjects and have a lot of useful tips available.

HardToLove


On Jul 08 06:36 AM BPYHO wrote:

> I hear everyone congratulating this guy (and it is a good article).
> However, where was this article a month ago when everyone and their
> mom was shoving Nat gas down our throats!? Talking about ratios,
> other Nat gas plays besides UNG to avoid contango, ect.... Publishing
> this article now doesn't do the suckers (Im one of them) any good,
> it would have been nice if you (or seeking alpha) published an article
> like this one earlier.

Jul 08 07:42 AM

[Maxe Paul:]

You can hardly blame other people for your "bottom picking" can you? Take some responsibility for your own actions.


On Jul 08 06:36 AM BPYHO wrote:

> I hear everyone congratulating this guy (and it is a good article).
> However, where was this article a month ago when everyone and their
> mom was shoving Nat gas down our throats!? Talking about ratios,
> other Nat gas plays besides UNG to avoid contango, ect.... Publishing
> this article now doesn't do the suckers (Im one of them) any good,
> it would have been nice if you (or seeking alpha) published an article
> like this one earlier.

Jul 08 08:08 AM

[Mmarrkk:]

Maxe Paul:

What????? Take responsibility for our OWN actions? Are you serious? Didn't you hear BoBomma tell us that those evil mortgage lenders FORCED us to sign those horrible house loans on homes we couldn't afford?? And those evil tobacco companies forced us, yes, held us down and crammed cigarettes in our mouths, and made us smoke! And those evil oil companies...don't get me started!

And those racists 401-k sponsors are not making us save enough!

C'mon...BoBomma said Change Was Coming and we would be able to rely on the Gov't to handle all our problems! Now, you are telling us to take responsibility for our own actions? Who are we going to believe? You or the Golden Child, The Annointed One, His Excellency BoBomma?

Okay, you are right!! But there are far too many people in this country who can't take responsibility and want to blame it on others. Heck, that feeling/belief got our current Marxist-in-Chief elected along with his band of crazies in the House and Senate. So now, we pay for it...pay for it big! Higher taxes, higher fees, Crap and Trade and Swindle and Confiscate, Gov't Take Over of Healthcare, UAW take over of GM and Chrysler.

Guess I'm just a racist hick who makes too much money and doesn't want to help "you know, spread it around"!

Jul 08 08:57 AM

[optionsgirl:]

There were plenty of articles and comments cautioning that UNG would fall after the rollover of contracts, which they completed around June 17th. That's exactly what happened. Freya's long term view is based on the facts. In the meantime, anyone in UNG at this level, who wants to hold the position, can hedge with a put, or sell a call, and hold that way. In fact, you can do both. If you think that natty will fall to the previous low around $3.30 and not go much below that, it seems to me the downside risk is fairly limited.

Jul 08 09:16 AM

[BPYHO:]

U R an idiot. I accept responsibility, I was just stating the FACT that it would have been nice if SA had posted something like this a month ago.


On Jul 08 08:08 AM Maxe Paul wrote:

> You can hardly blame other people for your "bottom picking" can you?
> Take some responsibility for your own actions.

Jul 08 12:29 PM

[Reginald Si...:]

Mr. Kelly,

the recent low was at the end of April at 3.25 ....So, today the price is around 3.36...storage estimates are always revised downward usually when prices are depressed...I think we are at the bottom and I suspect that 3.25 will not be violated...I think we will see a double bottom and then UNG will be in play bigtime...The time is now in my humble opinion.

Thanks for your article

Jul 08 10:05 PM

[Ricard:]

It would have been nicer still if you had been the one to do the research and had posted your own article.


On Jul 08 12:29 PM BPYHO wrote:

> U R an idiot. I accept responsibility, I was just stating the FACT
> that it would have been nice if SA had posted something like this
> a month ago.

Aug 23 09:31 PM