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Published: September 29, 2010
The numbers are out
and it’s official: this year’s summer was the fourth-warmest on
record, according to the National Oceanic and Atmospheric
Administration. Moreover, on a population-weighted basis, it was
perhaps the warmest summer on record in the United States.
Yet here we are with natural gas prices stuck below $4.00/mmbtu,
down substantially from levels above $5.00 in June and above
$6.00 in January.
As the second-most consumed fuel for generating electricity
after coal, record heat would typically translate into record
demand for the
commodity, as well as elevated prices. Indeed,
benchmark coal prices are up nearly +25% from last year, but
gas prices are actually down -20%.
So what happened?
It all boils down to supply. Flush with capital from debt and
equity issuances, natural gas producers have been drilling
frantically, taking advantage of prolific shale reserves to grow
output at a rapid pace. Joint ventures with deep-pocketed
international oil companies have been another source of capital,
while certain provisions in lease agreements obligate producers
to drill within a certain time frame. Taken together, these
factors have led the industry to maintain ambitious capital
expenditure plans despite depressed gas prices. In turn,
production continues to grow by leaps and bounds. Industry
sources indicate that output may be up by as much as 3.5 billion
cubic feet (bcf) per day from a year ago, a significant figure
in a roughly 60 bcf/day market.
In this context, we can see why natural gas
prices have largely shrugged off the record summer heat. That
demand is temporary, while the supply issues are more
structural.
Yet in spite of this gloomy outlook, natural gas may be poised
to rally. Thanks to scorching summer temperatures, inventories
of the fuel have gone from an 89 bcf surplus over year ago
levels in April, to a 185 bcf deficit currently. Furthermore,
the anticipation of winter typically leads to a seasonal upswing
in natural gas, and this year is likely no exception, especially
as prices have fallen to a level where a meaningful rebound is
very much achievable. All things considered, the commodity may
move toward $5.00/mmbtu during the course of the next month or
two, notably higher than current levels.
But before suggesting what investors should buy to take
advantage of this potential rally in natural gas prices, it is
worth mentioning what not to buy. The United States Natural
Gas Fund (NYSE: UNG) has received a lot of attention in the
past year, particularly from retail investors. UNG is an
exchange-traded fund (ETF) that attempts to replicate
movements in natural gas prices by purchasing the front month
natural gas
futures contract on the New York Mercantile Exchange, the
IntercontinentalExchange or the equivalent exposure on
over-the-counter markets.
As many UNG investors have learned the hard way, the performance
of the fund is not as straightforward as one might expect. [See:
The 6 Rules ETF Investors Must Know] It is important to
understand that the fund’s returns are impacted by both the
movement of natural gas prices as well as the structure of the
natural gas forward curve. Because prices are typically higher
in each subsequent month of the forward curve -- a condition
called
contango -- the fund takes a hit each month as it rolls over
its positions by selling contracts in the nearby month and
buying contracts in the next month. In fact, while natural gas
prices are down -20% from a year ago, UNG is down a hefty -46%,
illustrating that the fund is not the best vehicle for gaining
long exposure to the commodity.
Action to Take --> Instead,
investors should consider buying shares of low-cost producers
who can increase production and
cash flow in a modest commodity price environment. Range
Resources (NYSE: RRC), Petrohawk Energy (NYSE: HK), Southwestern
Energy (NYSE: SWN) and Ultra Petroleum (NYSE: UPL)
look attractive after falling steeply as natural gas pricing
expectations have declined.
These stocks' valuations are now accounting for lower commodity
prices, so any rebound in natural gas should lead to a rebound
in share prices. Each of these exploration and production
companies has accumulated enviable positions in some of the most
profitable unconventional natural gas resource plays ever
discovered. They should enjoy strong rates of growth regardless
of the fluctuations in gas prices, taking
market share from higher-cost producers if necessary.
--Sumit Roy
Contributor
StreetAuthority
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