Shishir Nigam's  Instablog

The USD vs the JPY is weakest in years. Yes, the DXY dollar index has been hitting new lows around 74. Yes, US government debt and deficits (the 2 infamous “D”s) have been skyrocketing and are projected to keep on growing in the coming years. Yes, the printing presses started by Ben Bernanke might be running faster than most people are comfortable with. And yes, the coming inflation will lead to further devaluation of the dollar which the government will not attempt to stop because they are happy to inflate away their piles of debt.

Just as important as deciding to go long natural gas is how that view is translated into an investing strategy. The value chain of the natural gas industry, shown below (Source: Wikinvest), provides a good overview. There are numerous investment opportunities throughout the value chain that can be capitalized upon.

Betting on the actual spot price:

1.       Buying natural gas futures outright – If you have access to the futures market, are experienced enough to understand its intricacies and have enough capital, then take a dip in natural gas futures. The December futures are already trading at a 14% premium to the November futures, on the hopes of a cold winter pulling up demand. Inexperienced investors should probably stay away from the futures market.

2.       Buying ETFs that hold natural gas futures – The biggest and most liquid one of these is the United States Natural Gas Fund (UNG). Many authors on Seeking Alpha have mentioned how UNG has been doomed by the contango in the natural gas market. UNG just finished selling its holdings of front-month contracts and rolled into December contracts this week. The premium on the December futures mentioned above means that UNG always sells low and buys high during rolls. For that reason, I would not recommend UNG. The Claymore Natural Gas ETF (GAS) on the TSX holds futures of Alberta natural gas, unlike the UNG which holds NYMEX futures. As it turns out, the contango on NYMEX futures is steeper than that on Alberta natural gas, helping GAS reduce its rolling costs. If you’re really sure of your bets, consider HNU, a 2x long natural gas ETF trading on the TSX.

3.       Buying natural gas royalty trusts – To avoid the costly contango issues, take a look at royalty trusts like Hugoton Royalty Trust (HGT) which pay monthly dividends based on the basis of the price of natural gas. However, many of these trusts behave in sync with the general stock market, which takes away from a pure play in natural gas.

Betting on the producers and movers:

1.       Buying the gas explorers, drillers – The most popular of these being Chesapeake Energy (CHK). The stocks of the producers however are likely to be affected by the general market conditions as well, as opposed to just the natural gas price. Another well-established company is Devon Energy (DVN) and like CHK, it is involved in both oil and gas markets. It is rare to find established companies which focus only on natural gas exploration. Internationally, Gazprom owns roughly 75% of Russia’s and Eastern Europe’s natural gas reserves.

2.       Buying the gas movers – Gas that is produced needs to be moved to where it’s needed. Natural gas is transported mainly through pipelines and some major players in this industry are NiSource (NI) - owner of the largest natural gas pipeline in the US, Northwest Natural Gas (NWN), Nicor (GAS) and Piedmont Natural Gas (PNY). All of them sport some very healthy dividend yields as well and have relatively solid balance sheets. A huge company involved in both producing and transporting gas is Encana (ECA). ECA is has a very stable revenue base thanks to a large portion of its business being regulated and it provides one of the best avenues to benefit from increases in natural gas.

3.       Buying a sector ETF – If you’re looking to invest in this sector but with diversification, look at a sector ETF like the First Trust ISE-Reverse Natural Gas Index fund (FCG) that replicates an index invested in natural gas exploration and production companies. It is one of the only ETFs that provides an opportunity to invest in a range of natural gas companies while having a reasonable expense ratio of 0.82%.

The best options for taking a long position towards natural gas, in my opinion, are either through getting direct exposure by investing in a commodity tracking ETF or investing in the gas movers which have the scale and size to provide a stable stream of dividend income while also standing to benefit from rising natural gas prices.

Disclosure: Long GAS on the TSE.
Image credit: Warrenski under a Creative Commons license

Why Natural Gas?

The NYMEX Natural Gas Futures (Front Month) hit 10 year lows of around $2.50 a few weeks ago and have since sky-rocketed to around $4.80 at the close of Oct 9, 09. In the process, it has very powerfully broken the downtrend that it was in for the past year. This could well be the best opportunity to get exposure to natural gas, here’s why:

The earliest known bubble was the “Dutch tulip mania” in 1637 which resulted in tulips contracts being sold for more than 10 times the annual income of a skilled craftsman (according to Wikipedia). And of course, shortly thereafter, the price of tulips crashed back to normal “flower levels”. All bubbles since have shared one thing in common – large groups of people thinking irrationally, all at the same time.

Mr. Market’s moods are currently being affected by a very interesting interplay of dynamics brought to fore by the various governments’ interventionist policies attempting to shore up the poor economy. Which dynamics will eventually lead the market forward is anyone’s guess, but I attempt to present here the major factors at play, without putting forward too much analysis and leaving the final assessment to the reader

In this first edition, I cover the top 5 reasons which are held up by market participants as justifications for being long and bullish of the market.

Top 5 reasons to be BULLISH

“I’ve still got my house and my company is now hiring!”

Employment, sentiment and home prices are some of the most important indicators of economic health these days. Many of these “economic fundamentals” seem to have turned their respective corners. Employment, seen as the most important (but lagging) indicator, peaked in March with weekly jobless claims touching roughly 670,000 and the most recent numbers hover around 550,000. Consumer sentiment, a direct indicator of the optimism/pessimism that consumers have about conditions, also bottomed in Feb-March at around 25, while the latest reading came in at 70.2 (above the all important 50 mark). Even the much maligned housing market seems to improving, with the Case-Shiller home price index improving for the first time in months to 132.64 in Q2, 09 (while still being down 14.9% year-on-year).

“Just look at those Asians”

The closest thing to a strong recovery has been visible clearly only in the Asian economies. In Q2, 09, India’s GDP expanded 6.1% year-on-year, while China’s expanded 7.9%. Amongst the Asian tigers, Hong Kong’s GDP grew at an annualized rate of 13.9% in Q2 from the previous quarter; South Korea grew 9.7% by the same metrics; And Singapore grew … wait for it … a whopping 20.7% annualized. As a point of reference, Singapore’s GDP was down 14.6% in Q1 sequentially and annualized, Hong Kong was down 16.1%. Talk about a V-shaped recovery! The regional stock markets in Shanghai, Mumbai, Hong Kong and Singapore have followed a similar trajectory. If Asia is where all the potential for future demand is, then this is a pretty good sign.

“What goes down…”

… Must come up; But hardly anyone was astute enough to be buying into the market when the March 9^th lows were made. As a result, all those people missed the early part of a huge rally. Even after the market had rallied 30%, investors were confused about the solidity of the trend and debates raged about “bear market rallies”. Since then, most investors have already bought into the market at some point or are waiting the next dip to buy in. Due to this, the market has seen every marginal correction being bought into by money on the sidelines jumping in, causing an upsurge as is obvious in the chart below. This was very obvious in July, just prior to the Q2 results. This mentality has lead to the “higher highs and higher lows” observed in all the major indices since March, creating the strong uptrend. The argument holds that the un-invested capital on the sidelines will continue propping up the market on dips.


“Q2 blew away expectations”

73% of companies that reported Q2 results beat analyst expectations ahead of their announcements. Results were not as bad as the investors expected them to be. But does that say more about the results or the expectations? It’s an open question, but Mr. Market liked what it saw, as companies were able to beat targets on their bottom lines. The initial March rally was sparked by positive Q1 results while the subsequent Q2 results in July helped bring the major indices up another 17%.

“I’m still buying Japanese”

Global trade is seen as the life blood of the modern global economy and that life blood was drained in the last months of 2008 as the financial world came crashing down. That is why many of the export-oriented Asian economies had such a hard landing. However, those numbers are now looking up. In July, US exports were up 25% annually after reaching a low in April, while the US imports (driving Asian exports) were also up 29%. Another major indicator of health of global trade is the Baltic Dry Index (BDI) which tracks international shipping prices for dry bulk cargoes, such as raw materials. The BDI is one of the purest leading economic indicators because it provides indications of the demand to move materials of production and also because the BDI does involve any speculative players. While off its recent highs, the BDI has also risen to 2,431 from its December lows in the 600 range.


Disclosure: Long the market