Cash In On The Imminent Natural Gas Rally (UNG, RRC, HK, SWN, UPL)
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. [Read my colleague Tim Begany's take on Petrohawk]
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.
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Sumit has more than eight years of experience covering equity and commodity markets. Sumit’s work has been cited on Barron’s and Yahoo! Finance. Read more…