How To Play The Oil/Natural Gas Arbitrage

by: Burt Rothberg

Many readers are familiar with recent changes in the natural gas situation. To recap: new drilling techniques (fracturing and horizontal drilling) have unlocked an enormous new source of gas. The traditional markets for natural gas have not been able to absorb the supply, and much of the additional gas has gone to lower-valued uses such as electrical generation. Moreover, these same drilling techniques are now being used for oily fields, and are producing copious natural gas as a byproduct. The surplus is probably baked in for several years.

While this is happening in the U.S., the situation in the rest of the world is much tighter. Gas from older exporters such as Russia and newer ones like the Mideast and Australia are priced against oil. The final cost to the end-consumer may be double or triple the U.S. price. There are many shale deposits in Europe and Asia as well, but extraction is years off.

I can think of a few ways of investing in this. But before I go through them, note that buying natural gas futures (or an associated ETF) is not included. The problem with this is that a gas is expensive to store. Thus, when inventories are high, the market goes into extreme contango. Right now the one-year contango is 50%! That's a pretty big hurdle to overcome.

Another investment I am not a fan of is the drilling suppliers. It does seem clear to me that there will be a growing demand for the higher-tech drilling needed for the new techniques. For the next few years, this will be in the US, but eventually it will go worldwide. The problem for investors is that much of the technology is owned by gas producers, who are suffering from the very gas glut they created. Names in the pure equipment and service space include Baker Hughes (NYSE:BHI), Halliburton (NYSE:HAL) and Helmerich & Payne (NYSE:HP). Some of these stocks have been hit pretty hard since August, so they might be cheap. However, the larger names do much more oil-related than gas-related business.

It is likely that the U.S. - world gas price discrepancy will be arbitraged. Some analysts think this will occur as nontraditional markets for gas are developed in the US (think vehicle fuels). I do not agree with this. The cost of the infrastructure modification is just too great. Instead, it is more likely that the US becomes an exporter of gas. Several companies are working on this. One, Cheniere energy (NYSEMKT:LNG) actually has signed contracts with two overseas buyers and government permits. I have invested in the associated MLP (NYSEMKT:CQP). This has a 9% return backed by an existing pipeline. If the LNG export plan is successful, it would be a huge upside.

Another winner from the U.S. - world arbitrage is likely to be LNG tanker owners. There is currently an overcapacity of oil tankers, but LNG is a different animal. I like TeeKay (NYSE:TK) and the associated MLP TeeKay Partners (NYSE:TGP).

Finally, for those with a longer term horizon, companies with a position in European shale acreage are interesting. Western Europe will probably be wrangling over environmental issues for years, but the eastern European countries will be quicker. Poland is starting right now. Companies there include Marathon (NYSE:MRO), Nexen (NXY) and the small cap San Leon (OTC:SLGYF). Shell is in Ukraine. Another way to play this would be to short Gazprom (OTCPK:OGZPY), the main Russian gas exporter.This is already rather cheap because of political risk in Russia, but longer term it will have to compete with U.S. and European shale.

Disclosure: I am long CQP, TGP.