Natural Gas: The Bull and Bear Case and 2 NatGas ETFs

Includes: ECA, GAZ, SU, UNG
by: Irfan Chaudhry

Natural-gas stocks got investor's attention after Chevron Corp. (NYSE:CVX) announced it would acquire natural-gas producer Atlas Energy Inc. (NYSE:ATLS) for $3.2 billion. This consolidation brings attention to the only laggard in the commodity complex; natural gas. Among natural-gas companies, EnCana Corp. (NYSE:ECA) rose 2.8% to $30.31 and Suncor Energy Inc. (NYSE:SU) was up by 47 cents a share at $36.42 Tuesday. The price of natural gas (Henry Hub) at USD3.5/MMBTU is not justifiable, not sustainable and may not stay at this level for a long time. This, despite the fact that most of the energy research community believes that the outlook for natural gas (and UNG along with GAZ) is not promising.

Bear Case

It may be worthwhile to hear the bear case first , which is getting more attention these days:

  • The primary reasons for the free-fall in prices are the sizable natural gas inventories around the world combined with a relatively stubborn natural gas industry which refuses to slow production in the wake of a global recession and economic slowdown.

  • Ballooning inventories at +3 Tr Cubic feets of gas against annual consumption of 3 billion cubic feet per annum

  • CFTC Position Limits restrict investment inflows into the natural gas market

  • Regime change bringing in new supplies (recent spate of news about natural gas discoveries in the U.S.)

  • As the current contango in natural gas futures flattens, as evidenced by the large open interest on natural gas puts for November, natural gas prices may not recover until 2011. Even in that case, with large reserves still remaining and the majority of natural gas producers refusing to stop production, capacity may be reached rather soon, putting greater downward pressure on natural gas prices.

Bull Case

  • Widening Gap: The bifurcation between oil and natural gas began to play out this year. Many looked at the widening gap in the oil-to-natural-gas price ratio as an opportunity to go long natural gas. They thought it was merely lagging the recovery in oil prices by a few weeks. As weeks turned into months, the oil-to-natural-gas ratio has reached historic levels (over 28 times as of Friday against a normal of 9)

  • Natural Gas as a substitution to fuel oil on the higher end of the value chain and now coal from the lower end (priced at USD2.2/MMBTU). Increasing demand may pull up prices from a deep price well.

  • The cost of current production averages at USD3.1/MMBTU. Any price which is below this level eats into natural gas supply. The marginal cost of production is at USD3.32/MMBTU

  • Prices may help decrease the cost of electricity which may result in increased consumption of electricity, (and then natural gas whose largest use is in power production, followed by heating and industrial use.)

  • Mean Reversion of energy equivalent spread between natural gas and crude oil.

  • With increasing stress on clean fuels, natural gas usage may increase at the expense of coal and fuel oil, which should be medium term positive for natural gas price.

On Investment Vehicles

I suggest staying away from these funds for the foreseeable future and waiting to see if their managers can straighten out the mess that these funds have gotten into.

  • UNG: Those that bet on natural gas' recovery through the United States Natural Gas Fund ETF have felt the brunt of the pain; UNG is a mess. Shares are down +50% in 2010 alone, and 17% in the last 3 weeks to trade at $12, down from a high of $63.89 summer of 2008. The fund has also, for all intents and purposes, reached its position limits set forth by the CFTC, all but deeming UNG a closed-end fund due to its inability to issue new shares. The lack of new shares has led UNG to trade at an almost unheard of premium of 11% over its NAV.

  • GAZ: Having performed equally as badly, the Barclays IPATH Natural Gas fund has also been a big loser of late. Down 50% YTD and 11% in the past 3 weeks, GAZ has managed to keep its premium below 9%. Also, since GAZ's holdings are quite a bit smaller than UNG, the former fund may have an easier time in reducing its premium.

  • The best vehicles for those who have a conviction about natural gas are natural gas equities.

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Disclosure: None

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