Be prepared for some surprising outcomes.
The article "Natural Gas: The Buy of the Decade" created quite a stir among the Seeking Alpha community. Hysteria is now shifting to natural gas as reports circulate that supply has risen less than expected. Natural prices jumped, and now investors across the U.S. are talking about how to get in on the new natural gas bull market.
Personally, I believe that natural gas could be an excellent play, so long as investors trade it correctly. I will not rehash the fundamentals of natural gas here, as other articles nicely summarize the facts of this commodity. However, I am going to use correlation analysis to show investors - who do not wish to trade the futures - different ways to make this trade.
Context
There are three different ways to trade natural gas:
1. Trade /NG, the natural gas futures - The plus is that you are trading actual natural gas contracts. The downside is that you must manage great leverage and deal with rolling your positions over.
2. Buy a "pure play" natural gas ETF like UNG or GAZ - The positives here are that you are exposed to the futures market directly without having to manage the position. There are major downsides, however. First, you must deal with the losses that incur from natural gas' contango market, which is more severe than the oil market. Second, expect to pay a small annual management fee.
3. Buy individual companies - The upside is that you can participate in market runs as well as natural gas increases, assuming there is a positive correlation. The downside is that the companies can get hit hard during downturns when natural gas does not.
The charts below cover only the second two ways to place this trade. I will provide some commentary, but the purpose of the charts below are for investors to make their own conclusions on what stocks or ETFs make the most sense for their portfolios.
Correlation
A correlation of +1.0 means that the stock follows natural gas exactly, day-for-day. A correlation of -1.0 indicates that the stock moves exactly opposite natural gas.
For this study I correlated the price movement of the companies below to /NG for the year 2012. Also, I used a length of 10, meaning that 10 bars are used to calculate the correlation coefficient. This is the default option on most trading platforms.
Charts
British Petroleum (BP), current correlation: .509
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BP is far less correlated that one would expect, and correlation swings wildly.
Chesapeake Energy (CHK), current correlation: .490
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It is worth noting that Chesapeake did follow natural gas very closely up until the end of 2011, and even quite well through April of 2012. However, the leverage of the company sent it into a tail spin, hurting its correlation.
Clean Energy Fuels Corp. (CLNE), current correlation: .590
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Clean Energy is all over the place, reaching close to a -1.0 correlation.
Chevron (CVX), current correlation: .777
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Dominion Resources (D), current correlation: .958
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Dominion is very interesting because its recent moves up have mimicked the moves of natural gas.
Devon Energy Corporation (DVN), current correlation: -.292
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EOG Resources Inc. (EOG), current correlation: .043
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Barclays Bank DJ UBS Natural Gas (GAZ), current correlation: .818
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I recommend avoiding this ETF. Its volume is low and the correlation is not great. This security is a great way to miss or hinder a natural gas rally.
Cheniere Energy (LNG), current correlation: .655
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Royal Dutch Shell (RDS.A), current correlation: .774
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I have heard numerous investors say that Royal Dutch Shell could be a good holding to mirror natural gas moves. This chart proves otherwise.
Sempra Energy (SRE), current correlation: .878
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Sempra has seen a run-up that has mirrored that of natural gas. However, it just came from a correlation below -.75.
United States Natural Gas Fund, current correlation: .998
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UNG is by far the best "pure play." However, the high contango of the futures market makes this play costly, as the management team has to rollover each month's futures contract. About one year ago there was a stir that some traders were bidding up the next month's contracts on some ETFs that had to rollover, so ETF managers have wised-up on how to cut costs. Nonetheless, UNG still has high costs.
To make this trade, I personally prefer to use options so that less capital is tied up.
Right now I'm eyeing the 12 strike on the January 2013 expiration. The price of $6.20 per call gives a modest breakeven of $18.20, less than $.50 off from where UNG is trading now.
I like the 12 strike for two reasons. First, the delta is very high at .88, meaning that for every $1 that UNG increases, the option gains $.88. Second, the 12 strike has an open interest just under 1,200, making it more liquid than the 13 and 14 strikes.
Exco Resources (XCO), current correlation: .908
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Exco has a strong track record of staying in positive territory.
Exxon Mobil (XOM), current correlation: .800
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Selecting Your Stock
Investors should decide what makes the most sense for their portfolios. For example, do you want a very well correlated stock or one that is correlated more of the time? Then pick Exco Resources. If you prefer to roll the dice, then perhaps Chesapeake is a better play for you. In all, it is important to select the stock or ETF that most closely matches your appetite for natural gas.
If you would like a more detailed analysis on correlation in portfolios, this blog post does a good job explaining it. If you would like another trade idea, then you might enjoy this article on Nokia.
