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Keeping Perspective With Commodity Prices

|Includes:Cabot Oil & Gas Corporation (COG), UPLMQ

Any investor who is thinking about buying stock in an oil and gas company has to be concerned about commodity prices, because they drive the value of the assets of all companies in the industry. U.S. companies with natural gas weighted assets have been hammered over the past few years due to low natural gas prices at U.S. hubs. As investors, we shouldn't be concerned with where commodity prices have been, but where they are going. If I could model oil or natural gas prices I would have a bright future as a consultant, but that doesn't mean that I can't study the past behavior of commodities which have been very volatile (see graph below). Knowing this, I might buy a Cabot (NYSE: COG) or an Ultra (NYSE: UPL) today, even though gas prices might not turn around until 2013 or even 2015. (Note: COG closed yesterday at 32.82, down from its 52-week high of $45.00; UPL closed yesterday at 18.64, down from its 52-week high of $48.91.). The bottom line is, by buying today I probably get in near the bottom of the market. Now I might not see returns until 2015, but if my stocks double that year, we're still talking about a pretty decent three-year return on investment.

Source: EIA

While oil has enjoyed a relatively steady climb from a low of $10.82/Bbl on December 10, 1998 to $99.86 at market close on May 22, 2012, natural gas prices have been much more volatile. Over the 15-year time period studied, there has been three separate instances where natural gas has gained and lost 50% or more of its value during a two-year time period (see three volatility bands on graph).

Energy Equivalency: On an energy equivalent basis, 1barrel of oil generates the same amount of energy as approximately 6 million British thermal units (MMBTUs) / 6 thousand cubic feet (Mcf) of natural gas. Therefore, all else equal, we expect oil to trade at a 6x premium to natural gas. Because supply and demand forces enter the equation, we know that this is not always true; however it's worth noting that on May 22, 2012 WTI crude closed at $91.44/Bbl versus $2.55/MMBTU for natural gas, a 35.9x premium (versus the expected 6.0x). As recent as June 9, 2011, oil traded at a 20.7 premium to natural gas and only 10.8x premium on July 2, 2008. Is oil overpriced? Has increased natural gas supply due to shale gas production led to a justifiable slide in natural gas prices? Either way, one can bet demand for natural gas will grow quickly over the next few years.

When you look at the performance of the companies in the stock price graphs I've been talking about, keep in mind that these are historical performances and guarantee nothing of the future. As shown by the graph above, commodity prices are volatile, so don't expect gas to stay low indefinitely.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Stocks: COG, UPLMQ