A 5 Step Strategy For Investing In Natural Gas

by: Jeffrey Dow Jones

I get it. Everybody hates natural gas. It might be one of the few things in the world right now that both hedge funds and environmentalists can agree on. Just when you think prices have bottomed out, they find a way to slide even lower.

It's not without legitimate reason, either. All of this abnormally warm weather has been terrible for gas prices. The period of peak demand -- usually around mid March -- is drawing near. And we are dealing with a massive, gigantic, historic oversupply at present.

Natural gas has been a depressing ride for investors who have been long. There's a lot of emotion in this space right now -- my guess is that you probably already have a very strong opinion about natural gas one way or the other. But for those of us who have been sitting on the sidelines, watching all of this play out objectively, it's time to start asking whether it's time to make a move. For this piece, I'll be looking ahead, not behind. There's plenty of analysis out there chronicling how the market got to where it is today.

I'll spoil the punchline: I think there's opportunity here. I touched on it briefly in our Predictions for 2012 newsletter, but as you break it down even further, I think the case looks more and more compelling. Let's take a look at the four main dimensions of analysis and then explore a few ways to play it.

Step 1: The macro backdrop

Getting long in and around natural gas certainly isn't a unique macro thesis. There's always some energy analyst somewhere who's pushing for this trade. But the reason why it's worth talking about today is that there are several factors which all may come into alignment in 2012. The first is the macroeconomic picture.

Prices are lower. Prices for just about everything are lower today than they were last summer. The reason is uncertainty and slower growth. But when you look at the macroeconomic picture, you have to be really careful to separate what's going on today from what will be going in the years ahead. I know it sounds totally obvious and that you've all heard it before, but markets are forward looking things.

The economy of today was priced in months ago. The prices of today are based on what the markets see 6-12 months up ahead. And the prices of tomorrow will be based on what the market sees in 2013 in beyond.

This is where you have to start. Remember that great Wayne Gretzky quote? You don't skate to where the puck is, you skate to where it's going to be. So when performing macroeconomic analysis, you've gotta figure out where we're all going to be 6-24 months from now.

Where do you think the economy will be at the end of the year? Ultimately the macro backdrop is tough to assess. There's a lot of art and individual style that gets worked into this type of analysis. I'm on record as saying that it's been tough and it'll be tough for a little while still. The rate of economic growth has slowed down since the post-crisis bounce. But I see things picking up before this Christmas as uncertainty over issues like Europe and the election fade away. I think that some of the extreme consumer cautiousness that we're seeing now eases up a bit.

Another piece of this macro picture is the weather for next winter. I know that this winter has been historically warm, but are you betting on another record mild winter? Or would you rather bet on a return to normalcy? Natural gas is used to heat our homes so cold winters increase demand, and usually price.

For a longer term trade like this, those factors are both favorable tailwinds.

Step 2: The technicals

How long has it been since you've looked at a price chart for natural gas?

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It's pretty darn ugly. $2.50!

You're probably wonder just how low prices are going to go. Honestly, I'm scratching my head too.

Prices are now at the secular lows witnessed in the fall of 2009. These levels are the only shot at any sort of technical support in this market. After this, it's a technical no man's land.

Not that it matters that much, but it's worth mentioning that natural gas is now priced where it was for a long time in the mid 80's. At the time, that $2.50-2.75 acted as a rather firm ceiling.

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The best I can come up with on the technical front is that the market is extremely oversold. It's psychologically difficult to buy markets like this. And while it's impossible to know where the exact peaks and valleys will be, the one thing I do know about incredibly oversold markets is that when you start looking further out towards the long run, the probabilities are skewed towards a reversion to the historical mean. I can't tell you how low prices are going to go, but I can tell you that the odds of this oversold condition clearing in the coming months is where I'd rather bet my money.

I can also tell you that when most investors look at a chart that's going down, down, down, they have this deep psychological fear that it will go all the way down. And with stocks or bonds, the investments that most people are familiar with, that can absolutely happen. Companies can go bankrupt and they can default on their debt. But commodities don't go to zero. They're a price, not an indication of solvency. When you look at the fundamentals of the market, you'll see why every commodity market has a lower bound greater than zero.

Step 3: The fundamentals

Fundamentally, natural gas is a little out of whack right now. Actually, it's really out of whack.

The U.S. is consuming only marginally more natural gas today than we were back in the 1970's -- less if you adjust per capita.

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Production has outpaced consumption in recent years, but what's even more dramatic is the increase in potential production. Suddenly, you can't throw a stone without hitting a new shale gas reserve. Provided we all find a way to make peace with the methods of getting it out of the ground, these massive new reserves offer reason to feel legitimately more optimistic about our energy future in this country.

Last week I heard highly-respected energy analyst Stephen Schork point out that natural gas is now competitive with coal at these prices. We don't use a ton of natural gas for electricity generation in this country, but at these crazy low prices, maybe now is when we start doing so. It burns a whole lot cleaner than coal, too.

Markets have a way of organically working towards equilibrium. Right now, supply is way ahead of demand and the solution is simple: prices fall lower and lower until enough new demand at these low prices comes online to meet the supply. It's the first thing they teach you in Econ 101.

From the fundamental side, prices are now at a point where all sorts of new demand may finally arise. That's another tailwind for our trade.

Step 4: The politics

In case you've been asleep for the last few years, we're in the middle of a major bull market in politics. Investors around the world have increasingly turned their attention towards policy makers and institutions like the Fed or ECB for a clue about which way the winds will blow. I've added a political dimension to most of the analysis that I conduct, and I've noticed that a lot of other professionals have been doing the same thing.

It's no longer just about weaving together the macro picture, the technicals, and the fundamentals. The fabric of investment analysis also needs to contain threads of political analysis.

This is an election year, and like any election year, expect a lot of grand promises about changes that are going to get made. Whether or not these promises actually get delivered on is beside the point. The thing that matters is that every cycle, a few topics are going to get pulled into the spotlight and will appear in the headlines.

I think natural gas is one of them. In fact, I think it could even become one of the pillars of the presidential campaigns. It obviously won't be as important an issue as the health of the labor market, but our energy policy does matter. It matters more so every election cycle. People do care about this stuff. And ultimately, elections involving incumbents are about one thing: is the country on the right path? How we satisfy our energy needs are part of that path.

Let's face it, natural gas is the low hanging fruit. We're making a ton of it and we have the technology now to make a ton more. It's all domestic, too; the U.S. is the "Saudi Arabia of natural gas." We are a net exporter. Natural gas is dirt cheap and versatile. I mean, we are interested in energy sources that are cheap, plentiful, secure, and relatively clean, right?

2012 could be the year where the general public finally gets engaged a little more with natural gas. It seems so obvious. The major oil companies got on this trend a long time ago. They either started investing heavily in natural gas research & production, or gobbled up other companies that were already doing it. Apparently, they saw the writing on the wall.

Election years are years where everyday people feel like they get an actual say in what happens and so they pay attention to some stories more than they otherwise do. And there's an interesting story to be told about natural gas -- it's a legitimate source to power our homes and maybe, maybe power our trucks as well.

Politics and policy aside, I think all this talk could kick start a little speculation. Here's how it has performed in the last few election years:

Natural Gas Performance During Election Years

2008 -13.1%
2004 +26.2%
2000 +157.6%
1996 +77.2%
1992 +3.5%
1988 +11.2%

If you're on board with this idea, there are a ton of different ways to play it. Here are a few.

Step 5: Choose your vehicles

If you've got the knowhow, use the futures! Seriously. I come from the CTA world, and for trend trades or reversal trades, futures are always the cleanest way to play it. You have to be careful, though. If you don't have much experience in the futures markets, natural gas is not where you should start. Our company has been active in the futures markets for almost 30 years and some of the crazy stuff we've seen would probably make your head spin. About the only thing I can say about this world with certainty is that it is not a place for amateurs. Amateurs invariably get screwed. So talk to your financial advisor about this stuff first.

You can use stocks or ETFs to play this as well. You can use them in conjunction with raw bets on price action or you can use them on their own. There are few different tiers to look at.

The integrated majors have been taking natural gas seriously for a while now. They've either devoted a substantial portion of their balance sheet to natural gas research & production or they've gobbled up other companies that already did. A broad energy bet on companies like Exxon (NYSE:XOM), Royal Dutch Shell (NYSE:RDS.A), or Chevron (NYSE:CVX) works fine for this sort of thing, especially over the long run.

You can also play it via companies that are directly engaged in natural gas production like Southwestern Energy (NYSE:SWN) or Chesapeake (NYSE:CHK). Southwestern is the more expensive of the two and probably has the better growth prospects and healthier balance sheet. Chesapeake is very reasonably priced at book value and only 2.5x cash flow. It's also trading around long-term technical support. If it holds, you got in a very low price. If it doesn't and it violates that support, you can pull the trigger quickly and wait for a new entry point.

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Encana (NYSE:ECA) is even cheaper, at a scant 1.7x sales and trading under book value. They're giving you a 4.6% dividend yield, too. But you have to ask hard questions when looking at companies that have gone straight down, from 80 to 20 over a period of a few years. Is the dividend safe? Do they go even lower and get eaten up? There's a reason companies trade under book value, you know.

Devon (NYSE:DVN) is another analyst favorite. They're bigger and safer, with more stable earnings power and a manageable debt. Here in the mid 60s, the stock is also trading in the meat of historical support.

This is a really difficult environment for natural gas companies. If that scares you, then stick with the integrated majors who have other lines of business to lean on. You can also check out something like the IEO, which is the DJ U.S. Oil & Gas Exploration & Production Index ETF. It'll get you diversified access to a basket of these smaller- and medium-sized names and leave out the bigger, slower-growth majors [XOM, CVX, ConocoPhillips (NYSE:COP)].

If you do decide to dabble directly in natural gas companies, my suggestion is to use debt burden as one of your guiding principles. Look for names in this space that have relatively less debt. Companies with less debt won't blow up and their earnings won't be as impacted if their borrowing costs rise. (If you're lending money to a natural gas producer, you are asking for more interest in return these days, aren't you? I sure hope so.) There is no shortage of natural gas analysis here at Seeking Alpha.

Whatever you do, don't use UNG. Just don't do it. Please. UNG is strictly a trading vehicle for people with extremely short time horizons. If you happen to know a guy who knows a guy who has a crystal ball and knows which way gas is going to move tomorrow, then you have my blessing to go forth and use UNG to play it.

Understand the parameters

This is a long term trade. It's not about guessing where the price bottom is. It's about relating where we are today to where we'll be a year or so from now. There's a lot of negativity in the natural gas space right now, and understandably so. But when you conduct a broad, multi-dimensional analysis, the probabilities about the long term outcome become a little more clear.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. For additional disclosure, see TheDraconian.com/legal notice. The opinions presented here are the opinions of the author and may not necessarily be those of the firms Jones & Company or Draco Capital Management.