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How to Profit From the Rebound in Natural Gas Prices

Commodities / Natural Gas Nov 11, 2010 - 04:47 AM GMT

By: Money_Morning

Commodities

Best Financial Markets Analysis ArticleJack Barnes writes: I love autumn. The leaves start to turn color, and the first hint of winter is invigorating. It is also a great time to peruse each of the financial markets for the shorter-term, seasonal trades that are always lurking - if you know where to look, that is.

One place that's worth looking at right now is the global currency markets, where a major war is currently being waged. As part of the so-called "race to the bottom," the U.S. dollar is down 14% since June. This drop in the greenback has come at a time when a major bull market in commodities has broken out everywhere in the world.


Gold, silver, wheat and corn have all recently achieved multi-year highs. Cotton just hit its highest price in 140 years.

There has been an exception, however - a headline commodity that's been left behind. Indeed, this particular commodity has been in decline for six months, dropping almost daily. But that's about to change.

As we move deep into fall, the leaves on the trees will change color, die, and then fall to the ground. But the commodity in question will return to the land of the living, and will head for high ground - generating windfall profits for those with the courage to make their move right now.

I'm talking about natural gas.

Natural Gas Numbers
I am a Contrarian investor by nature. So it's no surprise that some of my biggest gains as a professional trader came after I bought something that was so far out of favor that only a lunatic would've followed my lead.

I love those trades.

Right now, natural gas is out of favor. So out of favor, in fact, that people do not realize the true value of what it represents in the U.S. market. The spot price of a cargo of liquefied natural gas, or LNG, is around $14 per thousand cubic feet (MCF). In the United States, the same British Thermal Unit (BTU) of energy in the form of natural gas is priced around $3.50 per MCF.

The drop in natural gas prices in the U.S. market was so precipitous that, in August 2009, the weekly average price was $2.72 per MCF. I love price differentials like this, because I know that a capitalist will find a way to arbitrage the difference.

Let's do some quick BTU conversions so that you can see what is happening here. If you take a barrel of crude oil, and divide it by natural-gas-equivalent BTUs, you would find that the ratio is 6-to-1.

What that tells us is that one barrel of oil is equal to 6,000 cubic feet (MCF) of natural gas. When you buy LNG on the spot market, it is priced as an equal with a plus-or-minus differential to crude oil. However, in the U.S. market, that same BTU value of natural gas is currently discounted.

The bottom line: If crude oil were priced using its natural-gas equivalents in the U.S. market, that "black gold" would be trading at $21 a barrel - a 75% discount to the $88 it was trading at yesterday, its highest price in two years. In late 2008, crude oil was in the low $30's. It's up 150% in 18 months.

That's the price differential that I'm talking about here. Crude bounced. Liquefied natural gas bounced.

But natural gas never bounced.

Why didn't natural gas bounce like its two other energy brethren? That's easy. Once the United States discovered an abundant supply of natural gas in its shale basins, the fear that this country would run out of this critical source of energy basically disappeared.

This new supply of natural gas is changing the way the United States views energy. In the past, we expected to have to use imports to meet our energy needs. But that may not be the case going forward.

But make no mistake. Natural gas is going to bounce. In fact, once the United States is able to export liquefied natural gas, conventional natural gas prices will rise to match worldwide natural gas futures contracts.

The Energy Cycle
Currently, the United States has eight liquefied-natural-gas import facilities, but only one small LNG export facility - and that's in Alaska.

So as the United States discovers more natural gas reserves, that gas is essentially trapped, and cannot currently be exported.

This gives domestic U.S. consumers of natural gas access to a very cheap source of energy.

Seasonal demand issues also affect U.S. natural gas prices. It's a fairly predictable cycle.

During U.S. winters, demand for domestic natural gas exceeds available supply, meaning the United States must pull natural gas out of storage to make up the difference.

This causes gas prices to climb each winter as demand increases. This storage is typically old converted gas fields, with compressors installed so that natural gas can be shoved back into the field, for use when it is needed.

Each spring, when the weather warms up, the U.S. demand drops and prices fall as the surplus returns. The natural-gas surplus allows the United States to refill its storage facilities, in anticipation of the winter to follow.

A few years ago, when the United States found itself running short of conventional natural gas, liquefied natural gas was considered the solution to long-term winter energy needs. At one time, more than 40 proposed LNG facilities were on the drawing boards - each of which carried a construction price tag of $500 million to $1 billion.

Today, six have been finished with a total of 10 locations that are available to import LNG to the U.S. market. But they currently all sit idle.

That may soon change.

The United States is looking to start exporting LNG.

The End of Foreign Dependence?
Liquefied natural gas is a commodity that America could use to free itself from imported Middle Eastern oil. In recent years, U.S. financier T. Boone Pickens has been a vocal advocate for change in the way the United States addresses its energy needs - and its so-called "energy security."

He has posted his thesis about how to free America from its energy import needs - and that thesis includes this excerpt:

"Transportation has to lead the way - it accounts for two-thirds of our oil imports. No energy strategy can be effective unless it promotes the use of domestic natural gas as a transportation-fuel-alternative to foreign oil/diesel, and the focus has to be on America's eight million heavy duty vehicles. The NAT GAS Act, a bipartisan bill proposed in both sides of Congress, would advance the use of natural gas as a transportation fuel."

It won't happen overnight, but with intentional changes to our transportation fleet - such as to railroad trains and long-haul trucks, for example - this country could become energy self sufficient.

For that to happen, natural gas will have to play a substantial role. That could boost demand, and natural-gas prices, over the long haul.

And that's just one of the potential catalysts for higher natural gas pries.

A Look at the Price Catalysts
Given what we now know about the U.S. natural-gas market, it's time to look at the catalysts that will ultimately send prices higher. First, however, let's do a quick review of where natural gas is today.

This key U.S. energy source is:

•Near its yearly lows, while other commodities are already breaking out to yearly highs.
•Is discounted in the terms of its BTU values here in the U.S. market.
•Prone to price changes based on seasonal shifts in demand.
•Slated to increase in price as the price disparity is exploited in the domestic U.S. market.
•Destined to remain a key energy source in the U.S. market, since this is the only major market in the world with significant and highly innovative storage capacity.
Natural gas is destined to be a major commodity story in the months and years to come, as winter demand kicks in and international spot prices continue to rise, and as the U.S. dollar drops in overall value.

It's time for us to go along for the ride.

Action to Take: It's time to invest in natural gas, one of the few key commodities that failed to take part in the global bull market in commodities. The devaluation of the U.S. dollar is causing a price arbitrage event to appear in the U.S. natural gas market, where prices are much lower than they are in the rest of the world.

In the next five years, a group of energy companies will be building LNG-export faculties in the United States.

That is going to close the market-price gap between liquefied natural gas and conventional natural gas. While the world has a lot of natural gas available, most of it is trapped in non-exporting or easily accessible locations.

We can expect that natural gas is going to bottom soon, as the weather gets progressively colder in the days and weeks to come. Let's invest in natural gas while it's still out of favor.

There are three quick-and-easy ways to benefit from natural gas prices. They consist of:

•An exchange-traded fund - specifically the United States Natural Gas Fund LP (NYSE: UNG).
•The futures approach, in which case I would be looking at the March 2011 contracts.
•The options on futures approach. This gives you the same type of leverage as the futures contract, but without the margin risk. If you only purchase calls on the futures, you will not be subject to margin risk in holding this position.
(**) Special Note of Disclosure: Jack Barnes holds no interest in United States Natural Gas Fund LP, or any company listed in this article.

[Editor's Note: If there's one thing top global investors understand, it's that you have to "follow the money" to reap the benefits of the best profit opportunities that are available at any one time. Money flows point out the next profit opportunities. Sometimes that means "following the money" from one sector to the next. Other times that means moving from one geographic market to another.

To make those moves successfully, investors need a compass or, better yet, a guide. And successful investors will tell you, one of the best guides out there is The Money Map Report.

This monthly advisory service - an affiliate of Money Morning - employs many of the same experts whose columns you read here each day. The difference is that The Money Map Report's straight investment analysis. Our writers use proprietary money-flow indicators to identify and isolate the most timely profit opportunities you'll find anywhere. For more information about The Money Map Report, please click here.]

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