Browse > Home / Commodities, Energy / The Bullish Case for Natural Gas

The Bullish Case for Natural Gas

Posted on: August 20, 2008 - Email Article - Printable Version

Charles W. Petredis

About the Author:

Over the last month and a half commodities have had a sell-off so severe that it is safe to say we haven’t seen anything like this in a very long time. You would probably have to go more than 20 years backwards to find a downward move this sharp. It is understandable that investors become paralyzed by fear during downswings of 40%+ in such a short period of time but when looking through market history you can see that the greatest investors made their fortunes when everyone else was busy feeling sorry for themselves. Whenever this happens I find it extremely comical that CNBC’s anchors are yelling about how the ‘commodity play is now over.’ It seems to me that they are very good at buying high and selling low. I realize that they are in the business of selling news papers, but as a responsible investor you cannot allow this artificial fear to guide your decisions in either the short or long term. (I wouldn’t allow CNBC to guide any of my decisions ever but that is a completely different story for another day.) A wise investor once said, “When there is blood in the street, buy land.” I recently have slightly changed this and have been telling myself, “When there is blood in the street, buy equity.” A good example of this is Aubrey McClendon, the CEO of Chesapeake Energy Corp. [CHK: 20.13, -2.23 (-9.97%)]. With the recent depression in natural gas related equity valuation there have been rumors that he is going to take a portion of the company private. To me this screams a buying opportunity sector wide as he would not be thinking about this if his company was overvalued.

Background Information

As many of you know natural gas is an energy commodity that can come in either a gaseous or liquid form, although these forms trade at different spot prices. To the right of this paragraph you can see a slightly outdated chart of natural gas. As you can see, natural gas has actually been more volatile than crude but gets about 1/10th of the press crude gets every day. Recently natural gas trades has been trading in a somewhat similar fashion to crude even though these commodities have completely different underlying supply and demand fundamentals. I see this as a sign that there are market inefficiencies developing in the natural gas spot price.

Historical Trading Ratio

One of the key components that I look at when valuing natural gas is the ratio at which it trades relative to crude oil. From a pure energy output standpoint, 1 barrel of crude oil produces the same amount of energy as 6 units of natural gas. From a historical data perspective since 1980, the average ratio of crude oil to natural gas has been 8.5:1. The reason for this is because the two commodities are not perfect substitutes. For example, you cannot just decided that you will start filling your car up with natural gas from now on because it is cheaper than gasoline. The difference between 6:1 and 8.5:1 is the substitution premium between the two commodities. For most of the last year the ratio has been hovering between 9:1 and 11:1 showing that natural gas has been slightly undervalued for a long period of time.

Using approximate data from today’s trading day with crude oil trading at $114.00 per barrel and natural gas at $8.00 per Mcfe the current ratio stands at 14.25:1. Simply this means one of two things are likely to occur in the near future. Either natural gas will increase in price to bring the ratio down or crude oil will decrease in price to bring the ratio down. There are good arguments for both of these scenarios, but I believe the much better argument is for the appreciation of natural gas prices.

The Benefits of Natural Gas

When comparing natural gas to crude oil, there are a number of areas in which natural gas stands out as the superior commodity:

Ease of transportation
Ease of E&P
Cost
Safety Concerns
Environmental Concerns
Long-Term Supply Fundamentals

I’d like to highlight a few of these points even though many of them are fairly self-explanatory.

Ease of E&P and Cost

One of the greatest traits concerning natural gas is the fact that the cost of production as a percent of spot price is way less than that of crude oil. Many of the better natural gas companies are producing an Mcfe of natural gas at a cost of close to $2.00. When comapred to a spot price of $8.00 this is only 25% of the spot price. Crude oil on the other hand is produced on average at about $65 a barrel and with a spot price of $114.00 the cost is closer to 57% of the spot prices. Obviously these numbers depend on a number of different factors ranging from location, the company producing, geograhpy, taxes rates, etc. The point is not to look at these numbers as exact figures but to grasp the concept that because natural gas is cheaper to produce on a unit basis it will over the long run appreciate in price at a faster rate than crude oil.

Safety Concerns

This is not a huge point but it is of concern to some people, especially environmentalists. Natural gas is only combustible under very specific circumstances. This occurs when the air has a concentration of 5% to 15% natural gas. Less than 5% composition and there is not natural gas to cause a combustion and more than 15% natural gas composition causes the air to be too “thick” to combust. (I am not sure of the science behind this but these are the numbers that I have been quoted from numerous sources, if anyone of you Bill Nye Jrs would like to explain to me how this works please shoot me an email.) On top of these facts most natural gas pipelines are not located near public areas so safety concerns are in most cases a non-issue.

Environmental Concerns

This might be my favorite point of natural gas, although I am in no way associated with green party theology and probably worry about the environment way less than I should. On average consuming the energy equivalent of natural gas and crude oil the natural gas has less than 60% of the carbon footprint of crude oil. Environmentalist may be able to complain about crude oil from their skewed standpoint but they have no leverage with natural gas because of how clean it burns. On top of this over time technologies will be invented to make the consumption of natural gas even cleaner. This has already been going on for crude oil and much progress has been made so I would tend to believe that going into the future more progress will come on the natural gas front in terms of environmental protection.

Long-Term Fundamentals

What I am about to write has no bearing on the near future or even the mid-term future but could be extremely important in the long run. I believe that when looking at a period of 30-100 years natural gas actually has better supply and demand fundamentals than crude oil does. Eventually because of geo-political tensions the United States and other western-thinking nations are going to try to move away from crude oil to gain energy independence, or at least rely on more democratic nations for their energy needs. Most of the world’s natural gas is located in Russia, Canada, and the United States. While it is impossible to say what is going to happen with Russia over the long-run, I am certain that Canada and the United States will remain free democratic nations and because of this natural gas will be much more sought after than crude oil from suppliers that may not have a nation’s best interest in mind. The United States has at minimum 140 years worth of natural gas reserves if we were to consume only natural gas from the United States. Currently less than 2% of our natural gas is important and this level of energy independence cannot be ignored by the politicians, the public, and investors forever. Eventually supply and demand economics in a free market economy will win out over any sort of poor economic or fiscal policy that is enacted.

Closing Thoughts

I believe it is fairly obvious that over the long term investors who rely on natural gas will be handsomely rewarded. Most people wouldn’t agree with me right now but being the guy who goes against the grain in investing isn’t necessarily a bad thing and in most cases is actually a good thing. I wouldn’t recommend investing in natural gas derivatives unless you have an extremely high risk tolerance or deep pockets. Instead, invest in equities that benefit from long term natural gas spot price appreciation. Names like Chesapeake Energy [CHK: 20.13, -2.23 (-9.97%)], Southwestern Energy [SWN: 29.79, -3.64 (-10.89%)], Petrohawk Energy [HK: 14.55, -2.70 (-15.65%)], Apache Energy Corp. [APA: 70.65, -5.33 (-7.02%)], Devon Energy [DVN: 67.93, -6.07 (-8.20%)], and ConocoPhillips [COP: 44.54, -4.54 (-9.25%)] come to mind quickly. A good way to keep up with commodity spot prices is at the following link:

http://bloomberg.com/markets/commodities/energyprices.html

-Charles Petredis

Disclaimer: The author is long CHK, APA, and COP, the author’s family is long CHK and COP, and the mutual fund the author manages is long CHK, SWN, and APA.

Share or Bookmark This Post: