Have we finally hit the bottom of the natural gas bear market?
I think there's a chance that we're almost there, because there's not much more than can go wrong for this commodity. Prices continue to be crushed is due to the huge imbalance between supply and demand in the US, which may worsen significantly as we approach a summer dry-spell following the mild winter we had.
The longer-term trend is also bearish, as hydrofracking has proven so effective in boosting production that the industry barely remains profitable. This chart from the EIA illustrates the production growth well:
This all combines to a worst-possible case scenario for any commodity, so there's little doubt that the huge declines we've seen already occurred for a reason. In addition, some analysts are saying that the US is going to reach maximum storage capacity later in 2012 based on current trajectories. This would surely drive prices to fresh lows, as upstream oil & gas companies would sell their glut of NG in desperation. How can we be near a price bottom in a situation like this?
There comes a certain point where the intrinsic value of the product (natural gas) is far too high relative to the market price. Even with improved extraction technology, drillers are beginning to cut back production. In an interview with Bloomberg, CEO Mike Stice of Chesapeake Energy (CHK) made some interesting commentary on the situation:
"Two-dollar gas prices are not sustainable.... Prices will rebound. You'll see a supply impact from these low gas prices. We had a perfect storm in terms of production and warm temperatures. It can't be repeated."
Although we might have to be patient, I think the idea is correct. Not only is ~$2 natural gas utterly ridiculous from the standpoint of nations that actually use the stuff in bulk (like those in Europe and Asia), but the commodity has indeed been hit by the perfect storm. In reaction to this, companies will see unfavorable margins and either cancel or scale back on natural gas operations.
Another trend is the increased use of natural gas by electric companies. Methane is clean, unlike coal, and offers a win-win market for natural gas producers and utility companies.
The timing for catching the huge falling knife of natural gas will be difficult, but I think the ideal buying situation will come closer to winter when the production cuts may begin to bring prices up again. In terms of the charts, I would expect a test of the lows made in May. If they're not breached that may be the ideal spot to buy and hold this commodity. The most direct method of doing this (outside of the futures market) is buying some shares of US Natural Gas Fund (UNG).
There are also a host of gas producers available. Chesapeake is one big example, although it may suffer egregiously if natural gas slides any more. In Q1 2012, the company actually went negative in operational income (although this hole was plugged by amortization which allowed positive EPS). As unnerving as this may sound, there's no doubt that Chesapeake stock would skyrocket upon a natural gas recovery, along with earnings.
Another idea would be ConocoPhillips (COP), which is a big play on natural gas that offers a very competitive dividend and big exposure to crude oil as well. Much of their success in producing crude oil has been offset by pain in natural gas.
I'd also keep in mind the huge differentials between US prices and those in Europe and Asia too, as natural gas transportation companies step in to narrow this differential. Cheniere Energy (LNG), a company I keep an eye on, is one prime example.
Ultimately, this investment thesis is more about timing than anything else, and playing as the contrarian. The natural gas market has been through hell and back. If you can wait for another wave of bearish sentiment on natural gas, I think we're going to see buying opportunities that will generate some truly outstanding gains a few years down the line. Think more than 100% returns if you're making a raw bet on natural gas itself.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
