The price of natural gas has been trading at levels investors have not seen for 10 years. The price of natural gas is an 80% discount from four years ago. It is extremely difficult for an individual to invest in natural gas profitably. There are four ways to gain exposure to natural gas: Exchange Trade Funds (ETF), Stocks, Futures, and Contracts for Difference. I will comment on the pros and cons of each strategy, and provide the PMCMG Inc. strategy ranking for each approach.
Natural Gas ETF
It is extremely convenient to use an ETF to gain exposure to natural gas. Natural gas ETFs trade on both the NYSE and TSX; ETF’s provides liquidity and potential to make use of put and call options. ETF managers have to rely on futures and swaps to provide exposure to natural gas. Currently, natural gas future prices are in contango (this is a term used to describe the fact that the price of the next month contract is higher than the current month). For example, the current price of the natural gas future contracts for November 2009 is $4.50 and the December 2009 contract is $5.41. Natural gas ETF's roll over their position each month. This entails selling their cheaper November contracts to buy more expensive December contracts. This month will create a realized loss of close to 20% of investor’s capital allocated to the ETF. When a commodities future price is in contango, it is not prudent for an investor to purchase commodity based ETF's.
PMCMG Strategy Ranking 2/5 – Reason: easy to purchase; but likely to disappoint because of current contango.
Natural Gas Stocks
It is easy acquire shares of natural gas producers. Many trade on the TSX and NYSE. Similar to ETF's, investors can make use of put and call options. There is a problem; natural gas stocks currently have a higher correlation to the stock market then the spot price of natural gas. Most pure play natural gas stocks are trading at 52 week highs, even though natural gas is trading at 10 year lows. For example, Chesapeake Energy Corporation (Ticker CHK-NYSE) could be considered a pure play since 92% of their production is natural gas. Yet, Chesapeake is trading for $29, almost 3 times higher than its 52 week low of $9.84. Purchasing natural gas stocks is a poor way to gain exposure to natural gas.
PMCMG Strategy Ranking 1/5 – Reason: very little present correlation to natural gas price.
Natural Gas Futures
Natural gas futures allow investors to trade the current, front month contract of natural gas. Futures are extremely liquid; this allows investors to express their views bullish or bearish view by either investing short or long. The futures are the institutional solution of choice, but the minimum size of investment can be a problem for individual investors. Currently, each contract requires a minimal investment of $25 to 50K USD per trade. This makes it challenging even for well heeled investors to leg into a trade. Investors also have to manage the contract rollover risk themselves; this may require a monthly close out of their positions.
PMCMG Strategy Ranking 3/5 – Reason: great institutional solution, but high minimums make it difficult for individual investors.
Contracts for Difference (NYSEMKT:CFD)
CFD are similar to futures; the main difference is that investors can trade smaller amounts of CFD's. Currently, the minimum CFD purchase of natural gas is only $500. Even if an investor has a considerable amount of resources to allocate to natural gas, the low minimum allows them to leg into the trade in small amounts. Similar to futures, an investor can short natural gas and has to manage the monthly rollover prior to expiration.
PMCMG Strategy Ranking 4/5 – Reason: great flexibility with low minimums. The only downside is the investor still has to manage rollover risk.
Conclusion: There is no perfect way to invest in natural gas. Investors expect that one day spot trading similar to gold and silver will be available for natural gas. Until spot trading is available, CFD's are the best solution for individual investors.
William McNarland, CFA has been working in the investment industry for 15 years. He is a co-founder of PMCMG Inc. and My Global Analyst Inc. He has appeared as a guest on Money Line and taught at the University of Toronto. He resides in Alberta Canada. He can be contacted at email@example.com.