There's "blood in the streets" as one Natural Gas investor recently told me. Nat Gas is trading below production costs for most drillers and has been so cheap for the last couple of years that many companies in the natural gas industry are near bankruptcy. I smell opportunity.
First, let's look at why Nat Gas prices have fallen so much and why I expect them to be significantly higher in 5 and 10 years. Prices have fallen precipitously because of a dramatic increase in production from new technology. A decade ago, the bulk of US production came from the gulf region and was prone to disruption from summer hurricanes. In the last few years, tremendous amounts of new production have come online in places like Pennsylvania and New York via shale extraction. This is a true game changer and means we're unlikely to see the spikes of $15 natural gas during hurricane season again anytime soon However, the current price of $2.60 is unsustainable. These low prices are persisting because at many sites, drilling produces profitable crude oil and throws off natural gas as a byproduct. No matter how low natural gas prices go, it will still be produced at these sites.
While supply will gradually fall at current prices, the bigger change will come from demand. Historically, a barrel of crude oil has traded at between 6x and 10x the price of an mmbtu of natural gas. The low end, 6x, represents thermal parity, and the high end reflects the logistical advantages of crude over natural gas. This suggests a "fair" price of natural gas between $10 and $16. A tremendous price disparity can and probably will be maintained as long as our energy infrastructure continues to strongly favor crude. Currently, it would be much cheaper to run a car off of natural gas, but we don't have many cars capable of burning nat gas, nor do we have the fill station infrastructure ready. Alternatively, we may move to electric cars that run off the energy grid, necessitating far more nat gas burning power plants. Additionally, its clearly in our national interest to shift demand to natural gas; if we could replace 50% of our crude oil imports with natural gas that we produce domestically, this would dramatically reduce our dependence on "problematic" countries in the Middle East and South America as well as reducing our trade deficit by more than a quarter.
The bigger short-term catalyst for price appreciation will likely be the export of liquified natural gas (LNG). Currently, natural gas is basically a continental market. It's very expensive and logistically difficult to transport natural gas from the US to Europe or from the Middle East to Asia. A lot of money has been flowing into creating the necessary infrastructure recently and the Japanese nuclear disaster was the necessary catalyst for demand. Japan's imports of liquified natural gas have been surging, and the global demand for natural gas has followed suit as countries like Germany reduce their reliance on nuclear energy.
So why not just buy natural gas futures? Why bother with equities? Because I view this is a 5-20+ year secular trend, equities will likely produce a significantly higher return. For example, if you buy nat gas futures and they triple in value over 10 years, you've earned about 11.5% a year, not bad, but we can probably find companies that will produce returns on capital of greater than 30% a year in the same scenario. We're likely to benefit from both the accrued corporate profits as well as a higher valuation multiple. In other words, profitable companies churn out profits every year and they benefit from the higher earnings multiple that comes with higher natural gas prices. For bets of under 2 years, I generally prefer to stick with commodity futures, but for 5+ years, equities are usually preferable. Additionally, investing in equities lets us earn additional returns from our skill in individual stock picking.
While I have growing confidence in my ability as a stock picker, small natural gas companies are tough to value without industry expertise. So, I turned to my friend Josh Young, portfolio manager of Young Capital Management, and asked for his advice. Josh recommended 2 specific energy producers that he believes are very cheap relative to their peers: Gastar Exploration (NYSEMKT:GST) and Sonde Resources (NYSEMKT:SOQ) and I have a small amount of money in each. Josh thinks these are good buys even if nat gas prices remain weak and suggested that these are not the ideal picks if we specifically want to bet on nat gas prices rising dramatically. I like these stocks as a happy middle ground to profit even if nat gas doesn't strongly rebound while giving us significant upside if it does. I expect to periodically look for additional stock picks in the energy sector over the next five years with a particular focus on companies that provide upside to natural gas prices as well as companies that will profit from investment in natural gas infrastructure.
As an aside, I recently had the pleasure of moderating a panel at the University of Chicago. Jeff Yass, the founder and managing director of Susquehanna International Group (SIG), explained how he thinks about markets and was then joined by prominent finance professors George Constantinides and Ralph Koijen. One of Yass' interesting points was that in a high volatility environment, the median of a stock's distribution will be quite a bit below the mean; since stock's have unlimited upside, the most likely future value must be below the current price since the likely loss must be balanced against the small chance of unlimited upside gain. As a result, a 50% or even 80% fall in prices is not evidence of market inefficiency.