Good Entry Coming for Natural Gas Plays

Includes: APA, APC, FCG, UNG, XOP
by: Joseph E. Meyer

Tuesday's natural gas data from the U.S. Energy Information Agency helped send gas prices lower again on Wednesday, but that's good news. Anyone buying natural gas assets on the lows is going to be happy they kept at it a year or two from now.

Natural gas prices are down 23% year-to-date and the EIA's latest data will likely flat-line prices for a while after this 10-day run-up to around $4.14 for the December contract on the NYMEX. EIA said that natural gas inventories increased by 19 billion cubic feet to 3.84 trillion cubic feet, topping a record inventory set last November. That's a bear signal.

We know there is further risk on the downside because EIA expects that by the end of the winter heating season (March 31, 2011), around 1.7 billion cubic feet of natural gas will remain in storage, which is 114 billion cubic feet more than we had in this country at the end of last winter. Plus, that number is an upward revision of more than 70 billion cubic feet from the EIA's October forecast thanks to higher-than-expected reserve stock and greater production from the drilling companies.

To me, a quarter of volatile natural gas prices marks a good entry point into an extremely important natural resource. Assuming the U.S. economy picks up in the future, natural gas demand will rise from consumers and industry. Natural gas, therefore, is a good long-term hold for three to five years.

Natural gas becomes a buy when it moves closer to its 50-day moving average of $3.90.

Natural Gas Corp Index Up. Why?

Companies in the AMEX Natural Gas Index are up 5.3% this year and around 8.8% over the last 12-months. Companies like Andarko Petroleum (NYSE:APC) and Apache Corporation (NYSE:APA) have quietly outperformed the S&P 500 over the last month.

Much of those gains is because those companies in the index are also oil producers, and oil prices have gone higher than natural gas prices. But I continue to believe in the strong, long-term trend line in prices going back to the lows of 1995, and in the latest technical indicators that show natural gas is testing prior resistance in the $4-and-change region. A break-out is at hand to higher prices by the second half of next year.

Investors can get into this market through futures, options, equities of individual natural gas companies, and the more highly liquid exchange traded funds like the United States Natural Gas Fund (NYSEARCA:UNG), First Trust ISE-Revere Natural Gas futures fund (NYSEARCA:FCG) and Spider S&P Oil and Gas Exploration fund (NYSEARCA:XOP).

My preferred way to play this sector is to buy the group leadership with the lowest price-to-earnings ratio and highest dividend and put them away. If we see oil over a $100 a barrel in early 2011, natural gas will follow to higher prices. Not skyrocketing prices due to supply, but higher than where we are now.

Natural gas has built out a good and solid base price at these depressed price levels, so I believe higher prices will have the kind of long-term generational support needed to extend well beyond 2011.

I'm reminded of another commodity that was stuck at a base price for a long time before breaking out when fundamentals changed with demand: silver.

A 42% Upside?

I do not usually like to make comparisons of other markets to what currently is happening with natural gas, but I do see a similarity to how silver traded almost 10 years ago. Silver also went through the building of a long-term bottom in prices before beginning its current bull market run.

The serious money in any market always seeks out undervalued assets, and in the case of natural gas, that's exactly what it represents to the long-term investor. If we take natural gas at $4.00 per million BTU's, it is currently cheaper than coal and almost becomes a value play.

Natural gas is preferred over coal by U.S. industry because it is a cleaner burning fuel. The use of coal for power generation is currently one-third of global energy production and supply. It is interesting to note that natural gas is currently the other one-third component due to its various uses in industrial application. If we continue the current movement away from coal for environmental, political, or any other reasons, we will likely see a doubling of natural gas demand and consequently its price could go to $8 in the futures market. It's been as high as $15 per BTU in December 2005. I don't expect to see those levels any time soon.

Yet, consider this: over the last 10 years, the median price per BTU for natural gas was around $5.88. If we get to those levels in the next two to five years, we get a 42% upside in the price of natural gas in the futures market, and potential for higher profits among the big corporates in the energy sector. Not a bad time to consider natural gas on the lows.

Disclosure: No positions