Natural Gas: The Next Big Thing
by: Brian McMorris June 15, 2009

Why is Natural Gas so cheap (3.87 per mmBTU as of Friday) while Oil is moving ever higher? This is a significant disconnect that does not make long term sense. Historically, the average ratio between West Texas crude and Henry Hub natural gas has been 8.5 to 1. Currently, it is at a historic ratio of 19:1.

With oil at $72 per barrel, natural gas should be around $8.47. That represents a 125% potential pop in the price of natural gas if the price of oil stays constant. Many experts believe that oil is fairly priced right now, given the costs of exploration and extraction.

UNG is the easiest pure play on the price of natural gas. This ETF is based on natural gas futures and moves directly with that price. UNG trades for $14.50 as of today, but would be over $30 if natural gas normalized its pricing against oil. So, just on current relative value, natural gas is a value play with great upside potential in the intermediate term (12 months). But it is an even better play in the longer term (1-5 years).

President Obama and the Democrat controlled Congress will definitely pass some type of environmental legislation this year or early next. That legislation is aimed directly against carbon and its role in global warming (or the theory thereof, since it is not conclusively proven). In the next several months, either a "Cap and Trade" or a straight up carbon tax will be passed. The moderates in Congress and most of the heavy industrial world, faced with the reality of some type of legislation, are rallying behind a carbon tax for its simplicity and for the fact that the cost can be passed along to the consumer much more efficiently and without the distortion and potential fraud of cap and trade.

For natural gas, either scenario is very attractive. Natural gas per BTU of energy, is much cleaner than oil or coal, the two primary fossil fuel alternatives. So, if a carbon tax is passed by legislation this year, natural gas will immediately become more competitive. Its historical relationship to oil should decline even below 8.5. If it moves to 7.0, then the relative cost today should be $10 per mmBTU for natural gas.

Longer term, with or without a tax advantage over oil, natural gas promises to be used as a transitional fuel to alternative energies like solar, wind and geothermal. T Boone Pickens has proposed, and spent a considerable portion of his wealth, promoting the idea of natural gas powered vehicles. Once fuel cell powered vehicles become practical, within 10 years with government encouragement / subsidy, natural gas is likely to be the first fuel used by such vehicles. This reality will be encouraged if Pickens is successful in getting existing fuel stations in North America to add natural gas to their product offering at the pump.

Pure hydrogen vehicles are a better environmental option, since the byproduct of the chemical reaction is pure water. But the manufacture, storage and distribution of highly combustible hydrogen has many science, engineering and production problems yet to be solved.

So, how can we benefit from this megatrend?

The Canadian Canroys are one good way to anticipate this new trend. Much of North American natural gas is in the western provinces of Canada. I have owned and benefited from Pennwest (PWE), Pengrowth (PGH), Provident (PVX), Daylight (DAYYF.PK), Baytex and Harvest Energy for many years (until last July when the entire commodity complex hit the skids). U.S. based producers include Anadarko (APC), Chesapeake (CHK), XTO, Southwest Energy (SWN) and Lynn Energy. All the above offer decent dividends, though not nearly as attractive as a year ago, so there is somewhat less reason to buy and hold as there was in the past.

For extra leverage, sell "In the Money" UNG put options on the October $18 strike price (UNEVR) for around $4.50 premium per share of underlying stock (with the stock price at $14.50 as of today). This buys $1 of downside protection and provides over $3 of upside opportunity. If the price finishes above $18 on October 16, the puts will expire worthless and you will keep the $4.50 premium. The stock price of the UNG ETF will only need to move to about $5.00 from the current $4.00 for this to happen. But execute a "Buy to Close" order any where along the way, for example, when the premium falls to $2 for a double on your investment (times 5 for the inherent leverage of options) to lock in profits. This gives a 500% return in less than six months.

Because the market, especially commodity stocks, looks ready to correct, it may be prudent and profitable to wait on this until after a market correction. I am looking for a move back down to S&P 500 of 875 in the next couple of weeks. Once that move is done, it may be possible to sell the same puts for $5.50 (with the underlying UNG at $13).

Have fun making money.

Disclosure: No Positions