Drilling For Natural Gas Returns: Stocks & ETFs Vs. Futures

June 04, 2012

A perennial underperformer, natural gas is attracting attention again, from Main Street to Wall Street.

 

As domestic natural gas production has reached record heights over the past few years on the back of high-tech “fracking” methods, natural gas prices have in turn been in a free fall, taking investment returns with it.

But the mood about natgas and its potential returns have been revived with a rally this spring that saw prices surge more than 40 percent. But reality is settling over the markets again.

Natural gas prices have fallen below 2.40/mmbtu this week, giving back about half their spring rally. Investors, though, are putting the energy commodity on their “watch” list, just the same.

This newfound attention is a stark contrast to the recent past.

For years, natural gas investors were akin to parched drifters, traversing the Sahara Desert, hoping against hope that the pool of water on the horizon isn’t a mirage, and that a nice, cool drink is only moments away.

Unfortunately, the natural gas market has been more mirage than manna from heaven for investors, as natural gas prices have dried up — and then some.

Consider this track record . . .

  • Prices − Natural gas prices had fallen precipitously since 2008, when the Great Recession started. Natural gas futures prices fell to $1.94 in April, a four-year low, from $12 in April.

  • ETFs − Natural gas exchange-traded products, like the United States Natural Gas (NYSE Arca: UNG), have produced abysmal results for investors. UNG is trading around $19 in late May, down from a 52-week high of $50.52. Its year-to-date return is -38.39 percent, but even that figure looks better than its three-year average return of -49.22 percent.
  • Stocks − Natural gas stocks, as exemplified by major producers like Chesapeake (CHK) and Encana (ECA) are off significantly so far in 2012. Chesapeake has seen its share price fall by 40 percent since March 1, while Encana fell to a yearlong low of $17 per share in late May, and is trading at $19 per share in the first week of June.

 

 

 

Rising Prices Boost Natural Gas

But all may not be lost for energy investors, as natural gas prices have sought — and claimed — higher ground in May.

Natural gas contracts had climbed to $2.75 per million British thermal units (mmbtu) at the end of May before sliding below to $2.40/mmbtu in early June.

That spring run-up in gas prices triggered a closer look at natural gas by investors, who are beginning to edge back into the sector.

What’s driving the increased interest in natural gas stocks? Here’s a snapshot:

  • First off, falling gas prices had spurred an increase in demand among consumers — especially business consumers in the trucking and shipping industry. Cheap natural gas prices, especially when they fell below $2, drew big interest from electrical generators, many of whom switched from coal to natural gas.
  • Second, natural gas companies have loads of inventory they’d love to move. U.S. providers have largely been unable to export natural gas, and that’s left plenty of cheap natural gas on the table.
  • Third, shale gas is growing cheaper and more abundant. The U.S. Energy Information Administration reports that U.S. natural gas production rose by approximately 17 percent between 2006 and 2010, climbing to 21.6 trillion cubic feet (tcf) in 2010, a 37-year high. Driving production is a huge spike in domestic shale gas production, which grew from about 3 billion cubic feet per day (bcf/d) — accounting for 5 percent of overall production in 2006 — to 13 bcf/d, roughly 23 percent of overall production by 2010.

 

Playing The Upside

What’s the best way to play the “boom” in natural gas?

The trick, money managers say, is to try and hedge against potential declines in natural gas, buy at good values and keep adding to your natural gas portfolio as select opportunities arise.

That could mean taking the route of easiest access, and playing natural gas ETFs like UNG, along with other major funds like the United States 12 Month Natural Gas (NYSE Arca: UNL) or the Teucrium Natural Gas Fund (NYSE Arca: NAGS). But natural gas ETFs have significantly underperformed over the past few years, and UNG is “exhibit A.”

That leaves two paths for investors: natural gas stocks or natural gas futures. Choosing between the two leads investors down that well-trodden Wall Street path of “risk vs. reward.”

Which fork in the road to take — and why? Hard Assets Investor asked some Wall Street money managers to shine a spotlight on both options. Here’s what they had to say . . .

What’s The ‘Purer’ Exposure?

Tyler Kocon, portfolio manager at Minneapolis-based Split Rock Private Trading & Wealth Management and a close observer of the Bakken shale natural gas reserve, says futures are the “pure” play for natural gas investors.

He says over the next 12 to 24 months the “largest upside” on natural gas is through futures — but you have to know what you’re doing.

“If you are not worried about picking a place in time, then we believe that the largest upside over the next 12 to 24 months is represented by futures contracts,” Kocon says. “However, it is important to realize that tying invested capital to a futures contract simultaneously ties that capital to a fixed point in time where investment decisions must be executed.”

 

 

Kocon also said futures allow investors to detach themselves from any of the negative aspects and adverse developments that can be presented through stock ownership. He cites the case of Chesapeake Energy, which has seen a significant reduction in stock price over the last two months, even as natural gas prices have risen.

“The recent events unfolding around Chesapeake Energy is a great example of that theory,” he says. “Even as natural gas prices have traded more favorably over the last several weeks, Chesapeake stock has taken a turn for the worse on news surrounding their financial situation. Futures contract holders simply don’t have nearly as much exposure to this downside.”

Still, there is a caveat here, and a big one. “On the contrary, due to their pure-play status, futures contracts have very little downside protection in the event that negative reports on the natural gas market present themselves,” Kocon says. “In this situation, it may be prudent to capitalize on the potential dividend protection that a natural gas stock may provide.”

Risk Vs. Reward

Kim M. Pacanovsky, managing director and senior research analyst of oil and gas at MLV & Co. in New York, says choosing between natural gas stocks or futures contracts largely depends on “how much of a risk taker you are.”

“In general, I would rather be in stocks than futures because I believe it lessens risk,” Pacanovsky says. “For example, many companies with large undervalued natural gas positions have made huge strides towards establishing or growing crude oil production. They have pulled capital expenditures from gas projects and reinvested in oil projects but in many cases still have large [but declining] gas production, acreage and future development locations. So if gas comes back, these gas acres will move the stock, particularly as they commence reinvestment.”

Pacanovsky has a caveat, too.

“On the other hand, if gas languishes for another year, these companies have growing oil production to produce revenue and cash flow growth,” she adds. “As far as stocks are concerned, I would look for companies with growing crude production in high-rate-of-return regions that still hold large Marcellus or Haynesville acreage positions.”

Upside Vs. Downside

Rick Scott, senior managing director of L&S Advisors Inc. in Los Angeles, has invested in energy companies for 30 years, including E&P companies, master limited partnerships, refineries and integrated oil companies, among others. He says natural gas stocks may have an advantage for regular investors, and it’s all about capitalizing on low expectations and high upsides.

“When compared to natural gas futures, natural gas stocks are the smarter play because they are more likely to capture all of the upside of the market and less of the downside,” Scott notes.

“Simply put, if the price of natural gas increases, natural gas stocks are likely to increase in value as well. However, if the price of natural gas falls, there is a chance that the stock will remain steady. That’s because expectations for natural gas stocks are currently so low that an uptick in the commodity will drive stock prices up, whereas a decrease in price will not necessarily have a significant effect on their value,” he added.

If you want to pursue natural gas futures, Scott has some advice there, too.

 

 

“When looking at natural gas futures, investors should look out for supply constraints in North America,” he says. “The price of natural gas is currently determined by supply, and an oversupply would drive the price down. When looking at natural gas stock, investors should look at company fundamentals, such as balance sheet, EBITDA, CAGR, assets and revenue stream — in addition to the commodity price, of course.”

No Mirage

By and large, choosing between natural gas stocks, ETFs and natural gas futures is a matter of which decision will allow you to sleep at night.

For the risk-adverse, or for those who don’t follow the market closely, futures may mean biting off more than you can chew, with stocks the safer play and ETFs offering the easiest access.

But if you follow the commodities market closely, and don’t mind kicking some tires and getting some real data before you trade, futures may tip the scales toward more “reward” than “risk.”

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