I think the most important thing for an investor to know is his own limitations. So for years I avoided making any investment decisions that were based on the direction of interest rates, commodity prices or geopolitical events. I focused instead solely on the valuation of individual companies when making investment decisions.
My focus on the specific company level was adopted because I took my investing approach from Warren Buffett, and his thoughts on economic forecasting are captured in this paragraph in the 1994 Berkshire Hathaway Shareholder letter:
"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist."
In recent years however I have allowed myself one indulgence in making investment decisions that are driven by an economic forecast. I believe that it is painfully obvious that the world is getting very close to the point where it can't increase daily oil production fast enough to keep up with the demand growth from the billions of people in emerging economies chasing the Western lifestyle. Oil prices over the long term simply have to stay at elevated (as in over $70 per barrel) levels and could potentially go much higher.
This winter I've been contemplating whether I should allow myself a second indulgence and try and invest to take advantage of a recovery in natural gas prices from the current ridiculously low levels. This weekend my interest in natural gas was once again piqued when I read Jeremy Grantham's annual letter. Grantham, who is one sharp cookie, made the following comments regarding natural gas:
"At the opposite end of the resource spectrum to record-priced Iowa farmland is natural gas. Natural gas is, for most purposes like home heating and electric utility plants, a better and cleaner fuel than oil or coal, but is for technical reasons in distress: there have been several recent decades in which the BTU equivalent price for natural gas did, at least for a second, reach parity with oil. But now it is at just 14% of BTU equivalency, the lowest in almost 50 years. Everyone who has a brain should be thinking of how to make money on this in the longer term."
At $3/mcf and lower I feel pretty confident in saying that there are very few (if any) natural gas wells being drilled in the United States and Canada today that are making any money. And we are beginning to see capitalism going to work on eliminating these uneconomically low prices.
Where we once had LNG import facilities, we are now going to have LNG export facilities to move natural gas offshore and into higher price environments. Oil and gas producers are rapidly shutting down natural gas drilling and moving those rigs to oil and liquids properties. And although it is slow going progress is being made towards adopting natural gas as a viable option for fueling North American vehicles.
I think natural gas prices have to at least recover to the point where producers can make a reasonable profit drilling wells. I suspect that is in the $6/mcf range and would think that at some point prices start moving towards that level.
I'm not at the point where I'm willing to risk my money betting directly on a natural gas price recovery however. I think betting on long term oil prices remaining at $70 plus is a much more secure investment, so why would I try and get too fancy and attempt to make another macroeconomic prediction? There is no sense diluting my best ideas.
What I will however look to do is find situations where natural gas offsets are thrown in as a free option. For example one of my favorite companies is Canadian unconventional light oil producer Petrobakken (PBKEF.PK), which has an 80% weighting towards oil (85% if you count oil and liquids).
I believe that Petrobakken is a very good investment today factoring in only the value of its oil assets. Additionally, Petrobakken has a couple of trillion cubic feet of natural gas in the Horn River and Montney plays in Northeastern British Columbia.
If natural gas prices recover, or an LNG facility is constructed on the coast of British Colombia these natural gas assets could add significant additional upside to an already attractive investment opportunity.
Another example of this approach would be Chesapeake Energy (NYSE:CHK) which I believe is going to be an attractive investment because of its unconventional oil and liquids resource assets in the Eagle Ford, Utica Shale and other areas. If natural gas prices also recover, Chesapeake is going to be an outstanding investment.
Disclosure: I am long CHK, PBKEF.PK.