5 Reasons Natural Gas Is Poised to Bounce by: Andrew Mickey March 30, 2009

Every once in a while, commodity prices fall so low, they can’t be produced cost effectively anymore. Inevitably, producers have to eliminate production and scale back or drop expansion projects to reduce supply. Inevitably, the commodity’s price comes climbing back.
It happens all the time. It happened when uranium fell to $7 a pound nearly a decade ago. It happened when oil fell to $10 a barrel a few years ago. It happened again to oil a few months ago when prices fell to $35 a barrel. It’s happened to zinc, copper, agriculture – every commodity.
It’s how the commodity world works. Booms and busts. The most profitable way to invest in commodities is to buy during the busts and wait for the booms. The profits can be magnificent.
Right now, one commodity is going through a “mini-bust.”
The price of it has fallen 75% in the past few months. A slew of reports about declining near-term demand and rising stockpiles have sent the price of it down even lower. Near-term prospects are grim, but it’s looking like a buy.
I’m talking about natural gas.
Mainstream Turning Down the Gas
Now, if you look at a few recent headlines, it’s easy to see natural gas is out of favor.
Bloomberg: “Gas Decline Signals ‘Meltdown’ Toward $3.”
International Business Times: “Natural Gas: A Victim of Its Own Success.”
Forbes: “[Department of Energy] Says Natural Gas Supplies Rise Unexpectedly”
There’s no denying natural gas has fallen out of favor. The bearish sentiment has only gotten stronger in the past few days. It’s getting ugly out there for natural gas. Traders who were holding out for a recovery are quickly throwing in the towel as prices continue to fall.
As with most out of favor, beaten down commodities, every time the price of natural gas drops though, I get even more interested. Here are five reasons why I’ve slowly started to buy natural gas.
1. Near-Term Outlook is Bleak – Over a year ago, Seth Klarman said:
“Most investors tend to project near-term trends—both favorable and adverse—indefinitely into the future.”
He’s dead right. Most investors fail to look beyond this next week- even though, in most cases, their time horizon is much longer. They’re doing it again in natural gas right now.
That’s why natural gas prices are so low right now. Natural gas is very expensive to burn. It’s more expensive than coal and nuclear as an electricity source. As a result, natural gas fired turbines are only used to meet marginal electricity demand. Normally, they’re only running during peak hours of the day when factories are humming, offices are open, and, in the summertime, when air conditioners are turned way up.
We can see evidence of this in the volatile swings for natural gas prices. When marginal demand is high, natural gas prices are very high. When marginal demand is low, natural gas prices fall very low.
Right now marginal demand is low. Factories are shutting down, businesses are shutting down, and thermostats (in buildings with electric heat) are getting turned down to help cut expenses. That’s why natural gas prices are so low relative to their recent highs.
As usual, Wall Street is projecting this near-term trend long into the future.
2. Supply is Getting Cut – When demand falls, prices fall. When prices fall, supply falls. It’s a basic rule of economics. Right now, the rules are hitting natural gas.
The number of natural gas rigs have been slashed nearly in half. Less than a year ago there were 1,600 natural gas rigs pumping out natural gas in the U.S. That was at the peak of the energy bubble though. Now there are less than 900 rigs in operation.
That’s not all though. There’s also something else unique to natural gas. The Dallas Fort Worth Star-Telegram reports:
“In the view of most producers, the sharply lower drilling will translate into declining production by year’s end. Natural gas wells typically experience a decline of at least 50 percent from their initial production in their first year, with lesser declines for several years before flattening.”
The combination of reduced number of rigs and reduced output from each rig will lead to a sharp reduction in supply. As we’ve seen in every commodity cycle for the past 100 years, low supplies eventually lead to higher prices.
3. Oil to Natural Gas Ratio – Oil and natural gas have always been closely related. It’s rare to find oil in the ground without natural gas. And vice versa.
Although the prices of both don’t move in lockstep with each other, they do have a relationship. The best way to look at it is with energy equivalency.
In energy equivalent terms, a barrel of oil produces the same amount of energy as a six Mcf of natural gas. So in dollar terms, this works out to a pretty wide cost disparity. The cost of a barrel of oil’s worth of energy from oil is $50. The cost of the same amount of energy from natural gas is only $22.2 (6 times $3.7 per Mcf).
There has always been some disparity in these prices because oil is so much easier to transport around the world and natural gas is usually limited to the continent it’s produced by (excluding liquefied natural gas). The ratio rarely gets so far out of whack though. On an energy equivalent basis, oil rarely costs more than twice as much as natural gas.
History shows, when oil prices rise, natural gas prices follow (in broad terms – there is very little relationship in the week to week volatility of oil and natural gas prices).
4. Inflation – Inflation is coming, eventually. The Fed’s number one priority has been to stave off deflation. Even though deflation is a natural consequence of a massive credit contraction, the Fed has proven its willingness to pull out all the stops to bring inflation back (and we haven’t even witnessed the most drastic actions yet).
Eventually, this will lead to inflation. Whether it’s hyper inflation, mild inflation, or anything in between, it doesn’t really matter. The Fed wants inflation and it will do anything to ensure it happens.
Of course, there will be consequences. One of those will be the nominal price (the price tag price) of real assets will go up. There are many ways to protect and actually increase your wealth during periods of inflation.
One of the best way is to own real assets. Most investors tend to focus on precious metals like oil, gold and silver as a hedge against inflation. Don’t get me wrong, there is a place for these in your portfolio. However, there are many other hard assets to own. Among my favorites are farmland, bridges, roads, and, at current price levels, natural gas.
5. Cap and Trade – As we discussed earlier this week, the installation of a cap and trade scheme is practically a lock. The current president is a masterful campaigner. Now he’s campaigning for the cap and trade legislation as part of his administration’s budget proposal.
Natural gas will be a clear benefactor of the cap and trade legislation because it is produces significantly less carbon than coal, America’s leading source of electricity. Natural gas-fired turbines produce 70% less carbon than brown coal and only about half as much carbon as coal-fired turbines.
In an era where carbon will add significantly to the cost of high carbon energy sources, the environmental friendliness of natural gas will make it an even more economical alternative to coal.
As you can see, there are quite a few reasons to start getting bullish on natural gas. These five are just the start though. There are a lot more.
For instance, the U.S. Department of Energy predicts 900 of the next 1000 power plants will be natural gas fired (and that was before the cap and trade system was even on the table). China recently publicly renewed its commitment to building electricity production capacity from sources other than coal. A few major corporations and government agencies have announced purchase commitments for tens of thousands of new natural gas fueled cars and trucks.
We could go on and on, but you get the point. Natural gas prices won’t stay this low for long. The natural gas boom will return. It always does.
In the end, we’re probably a bit early here. Natural gas prices have fallen 10% in the past two days and stockpiles are sitting at six-year highs. Frankly, the odds of a sharp rebound are slim, but a rebound will come.
As a result, I recommend taking action accordingly. There is a great opportunity to write covered calls against a position in natural gas ETF like United States Natural Gas (#HYPERLINK "http://seekingalpha.com/symbol/ung"UNG). Or you can start building a “starter stake,” which would allow you to dollar cost average, in a leveraged ETF like Horizon’s Betapro Natural Gas Bull Fund (TSX:#HYPERLINK "http://seekingalpha.com/symbol/hnu"HNU).
Finally, natural gas prices have been setting extreme lows. Last week natural gas prices fell to their lowest levels in six years. That means natural gas offers lower risk and greater reward than it has in the past six years.