Natural Gas: The Last Undervalued Commodity?

Includes: UNG, VDE, XLE, XOP
by: Bruce Vanderveen

The worst commodities of 2010 just might be the best in 2011. It often works that way. So, what was the worst of 2010? Natural Gas (down some 20%) and cocoa (down some 7%) take the loser's prize! And, sure enough, both are off to a roaring start in 2011.

We all love (and maybe even dream of investing in) cocoa -- aka chocolate. But, for now, let's ignore that tempting choice and look at natural gas.

Why Is Natural Gas So Cheap?
Natural gas prices are low for good reasons. In the past few years the new technologies of horizontal drilling and hydraulic fracturing in oil/gas shales has released a voluminous supply into the market -- driving prices sharply down. But with the price of oil steadily rising, environmentally friendly natural gas is more and more becoming the fuel of choice. Gas is now making inroads into electrical generation, vehicular use, and other applications traditionally handled by oil or coal.

"Fire in the Sky"
In the past, as natural gas came out of oil wells and was often just flared off -- thus the dramatic photos of flames over rigs in the night sky. Gas out of the well varies considerably in composition and must be processed before use. NGL (natural gas liquids such as ethane, propane, butane, and others), carbon dioxide, hydrogen sulfide and water vapor may also be present. High NGL gas, called "wet" gas, is often more profitable than "dry" or low NGL gas. NGL has its own markets.

Two Trends
First, oil production worldwide is dropping as easy oil becomes increasingly scarce. BP (NYSE:BP) doesn't drill 5 miles down below the ocean to win awards -- they do it because that is what they have to do to keep finding oil. Second: As mentioned above, we suddenly have lots of inexpensive gas. These two opposing trends -- price of oil up, price of gas down -- will inevitably shift energy markets to gas.

Overcoming the Barriers
I am confident that technology will eventually break down transportation and storage cost differentials between gas and oil. Look at General Electric's (NYSE:GE) recent sale to China of fifty 13-100 megawatt turbines (1 megawatt can power 500 - 1000 homes). These jet-engine like turbines can be used in a wide variety of applications including power plants. The tubines can be powered by several fuels including -- you guessed it -- natural gas.

Natural gas powered vehicles too are beginning to gain traction. Most automakers have CNG (compressed natural gas) vehicles in production. Countries such as Argentina, Brazil, Pakistan, and Italy are leading the way.

Why Invest in Natural Gas Now?
Most natural gas stocks hit lows early last autumn and are now rising. We may be past the dangerous "falling knife" stage of the multi-year declines of the last few years. Everyone agrees that natural gas has a bright future. Only the timing as to when prices will rise is debated. If you don't wish to try and time bottoms and do extensive company research consider ETFs.

"Safe" ETF Investing
There does not appear to be any ETFs which specialize in only natural gas weighted companies. There are, however, ETFs which include both oil and gas companies. I look at this as advantageous. Being invested in oil and gas provides for more stable prices.

Look at the SPDR Oil & Gas Exploration & Production ETF (XOP). You get a basket of midsized oil and gas exploration and development companies. The Energy Select Sector ETF (NYSEARCA:XLE) will get you a basket of large cap energy companies along with some oil service companies. The Vanguard Energy ETF (NYSEARCA:VDE) is similiar to XLE but has a lower expense ratio.

A Warning
Unless you are a day trader and know what you are doing stay away from The United States Natural Gas ETF (NYSEARCA:UNG) (death by contango). Far too many investors think they can simply buy UNG and wait -- a fatal mistake. UNG can go down over time even though the price of natural gas goes up.

In a Nutshell
I feel the long term move from oil to natural gas is just beginning and will open up many profitable opportunities for investors. Advancing technology will continue to break down the barriers to substituting gas for oil. Time is on patient natural gas investors' side.

Remember the ideas in this article are just a starting point for further research. Do your own due diligence before investing.

Disclosure: I am long NIB.