The Better Commodity Investment: Natural Gas Futures vs. Comstock Resources

| About: Comstock Resources (CRK)

A century old debate is still raging in the markets (more so today, with the introduction of commodity ETFs) and it has to deal with whether it is better to invest in a commodity or in the companies that produce the commodity.

What I will attempt to do over the coming days, months, years etc. is produce articles showing that my methodology, Mycroft Research (MR) can help the long suffering commodity investor make clear cut decisions based on capital appreciation through capital preservation. I do this by introducing history into the equation and thus allow investors to take a longer term approach to investing in the commodity markets.

The first part of MR is called Statistical Indicator Analysis (SIA);

For those new to SIA here is an introductory article explaining how it works.

And since we will be discussing commodities in this article, here is a further introduction using SIA to analyze the Fuel Oil Commodities. I only recently received the data on Natural Gas, so it was not included in the article below:

Therefore with the introductions out of the way let us present a chart of SIA for Natural Gas Futures [click all images to enlarge]:

Since the commodity “natural gas” does not produce earnings, has no income statement, balance sheet or cash flow statement, we are forced to analyze it just from the viewpoint of the price that it trades at and what investor sentiment is in relation to the various macro-economic forces that are associated with it, which affect its supply and demand.

These forces are part of what is called fractal geometry, which I define as “the infinite number of factors working together, eventually affecting the whole in some way.” In other words, for example, how does a war in North Korea affect gas prices in Texas and Siberia or how does an increase in car accidents globally, affect the sale of Ford (NYSE:F) cars in China or Bombay? As extreme as these events sound, everything is interrelated in some way to everything else and the culmination of all these infinite factors result in what we call daily life.

Fractal Geometry affects the trading in the pits of the global commodity markets every second of every day. Therefore it is extremely difficult to be able to come up with a strategy to predict the future of what will happen, so I do not try to do so, but instead try to determine the present value of anything I analyze.

MR uses history as its guide in analyzing stocks, commodities, mutual funds and indices and uses the statistical mean or an average resulting from 3650 trading days (not calendar days) as its guide. By doing so, the results of MR act as a hedge against having to watch the macro-economic events on a second by second basis, which we know is impossible.

Being a student of history, I have learned that history does indeed repeat itself quite often and that investor behavior has changed very little in the last 1000 years. Investors in the marketplace are motivated by fear and greed and have a tendency to panic on the downside, as well on the upside, more often than not. Because most investors do little, if any, research, most of their actions are based on emotion. Emotion is the most dangerous thing to use when making investment decisions, but nevertheless, it's how most investors operate, so it is a reality we unfortunately have to deal with.

In analyzing the SIA chart above, one will notice that Natural Gas Futures are trading at about a 17% discount to their SIA line (red line), which is currently $5.23. I have only been able to get data going back to 1993, so our first day of analysis (#1) starts on July 23, 2008 (the day the 3651st trading day was reached). On that day the SIA for Natural Gas was $4.66 and the market price for Natural Gas was $10.28 (down from a high of $13.91, achieved just three weeks earlier on July 1, 2008). Therefore, on July 23rd we had a price to SIA (P/SIA) of 2.21 and we currently have a (P/SIA) of 0.87. So we went from $13.91 to $4.32 in just 2 ½ years.

Someone unfortunate enough to buy Natural Gas at $13.91 and hold it to today lost -69% on their investment. MR states that the farther you go away from the SIA the greater your risk. At the same time the closer you get to par with or trade at a discount to SIA the lower your risk.

Analysis of Comstock Resources (NYSE:CRK)

I selected CRK as my first "commodity vs. stock analysis" as it is a pure play in the natural gas arena and is also one of its lowest cost producers. Therefore it is only logical that if given a choice of investing in natural gas or buying CRK, CRK should allow you the safety of not only getting exposure to the commodity, but also give you the safety of owning a company as well, which has a balance sheet, cash flow statement and income statement that you can track. Let’s examine now if this is really the case.

Here is the SIA chart for CRK:

As you can see from the chart above, investing in CRK would have given you the same roller coaster ride that the actual commodity would have, because investors in the stock during the run up in Natural Gas did not do their homework on the company and just piled into it as a natural gas play.

This behavior is dangerous as people are not investing, but are exhibiting group-think by joining the crowd, similar to how lemmings operate. As mentioned above, one would have lost -69% investing in natural gas, but had one invested in CRK instead they would have lost -71.25% during the same time period.

From a SIA point of view, CRK is trading at 1.23 times its P/SIA while Natural Gas is trading at 0.87 its P/SIA. Therefore when we run the MR commodity comparison ratio, 1.23/0.87, we find that CRK has a 42% greater risk to the investor than the underlying commodity does.

Qualitative and Quantitative Analysis of CRK

The following is an Owners Earnings (OE) Analysis of CRK and here is its data from 1986 to 2009:

The results show that CRK has generated $48.93 per share in cash flow (1986-2009) and spent $103.93 a share in capital expenditures to do so. Therefore the company generated $-61.00 a share in cumulative owners earnings (COE) and on Main Street its CapFlow average was 240% during those years.

For those new to the qualitative and quantitative part of MR, please click through for an introduction: OE and COE, CapFlow.

Most investors confine themselves to just analyzing cash flow when researching commodity producers and that is very dangerous, but before I explain why, here is a chart of CRK’s Cash Flow from 1986-2009:

From that chart, it looks like CRK is a very profitable firm, with positive cash flows as far out as the eye can see. This is a trap that most investors fall into, that can easily be eliminated in most cases by simply including capital expenditures in one's analysis.

Capital Expenditures by definition are funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations. Capital Expenditures when subtracted from Cash Flow gives you Owners Earnings or what I call Free Cash Flow.

If a company is spending two times the amount of money it produces in Cash Flow, then it will run negative and though it can sustain itself through borrowing or issuing new shares (diluting existing shareholders), eventually a day will come when it will have exhausted all its options and will fail. Utilities have done such things for decades, so it usually takes a very long time for these abuses to finally materialize, as the CRK’s COE chart below clearly shows:

Here is the CapFlow chart for CRK to complement the one above:

The conclusion that MR has reached is that by investing in CRK an investor would be taking on considerably more risk than investing in the commodity itself.

As for investing in Natural Gas ETFs, no ETF as of yet has reached its 3651st trading day, so we cannot analyze them using SIA yet.

Disclosure: No positions in Natural Gas Futures, ETFs or CRK