Seeking Alpha
Newsletter provider, ETF investing, long/short equity
Profile| Send Message|
( followers)  

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.

-----

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 (NYSE:APA), Chevron (NYSE:CVX), Quicksilver Resources (NYSE:KWK), Noble Energy (NYSE:NBL), Shell (NYSE:RDS.A), and Questar (NYSE: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.

Source: Why I've Waited to Buy Natural Gas