Is Now The Right Time To Buy Natural Gas Stocks? (FCG, WCAT, UNG, UNL, CWEI, PRMRF, NOG, PETD, SWN)

Looks like those great gains we’ve seen in crude oil haven’t translated to natural gas. In fact, natural gas will close out the year as one of 2010’s biggest losers, because ample supply has continued to tamp down prices. Inventories remain high, although, as a rule, they also tend to be highly cyclical, as seen in the chart below:

Spot Price vs. Inventories

Of course, the chart above doesn’t describe consumption, and that’s ticking back up: The most recent EIA Natural Gas Weekly Update references a report by BENTEK Energy LLC, which states that overall consumption of natural gas has increased by around 6 percent compared with the same period in 2009. Recent cold snaps in the Southern U.S. and Europe have helped push demand back up in the short term as well.

Unfortunately, the increased consumption just wasn’t enough to compete with the amount of supply both in storage and coming out of wellheads.

So with prices as depressed as they are, how have natural gas companies fared?

It would be easy to assume that, with the price of their product depressed, the natural gas companies would see their share prices plummet, but that just doesn’t seem to be happening.

In fact, quite a few natural gas companies have had amazing years—not only vastly outperforming natural gas (though it doesn’t take much to do that), but logging gains of over 50 percent and more.

Two ETFs that offer coverage of natural gas companies are FCG and WCAT.

FCG is First Trust ISE-Revere Natural Gas Index Fund (NYSE:FCG), which pulls 30 companies from the ISE-Revere Natural Gas Index, according to methods detailed on its website, including requirements mandating a certain level of natural gas proven reserves. Meanwhile, WCAT is the Jefferies TR | J CRB Wildcatters Exploration & Production Equity ETF (NYSE:WCAT), a relatively new energy ETF that, as of the end of November, allocated 60 percent of its portfolio to natural gas companies.

Both ETFs have done fairly well for themselves, especially if you compare them with the United States Natural Gas Fund (NYSE:UNG).

Natural Gas Equities

Both UNG and its longer-looking sibling, UNL—the United States 12 Month Natural Gas Fund (NYSE:UNL)—declined substantially over the past 12 months, with UNG falling more than 46 percent alone. FCG, on the other hand, is up 8.5 percent for the past 12 months, and WCAT is up over 17 percent since its inception in mid-January (for comparison reasons, the chart above starts at WCAT’s inception dates).

Of the 30 companies FCG holds, four show returns over 50 percent. But in WCAT, things are even better. WCAT, which holds 60 companies, tends to concentrate much more on smaller stocks—and when these wildcatters hit it big, their share prices tend to go through the roof. Since WCAT’s inception, companies like Clayton Williams (NASDAQ:CWEI), Northern Oil and Gas (AMEX:NOG), Paramount Resources Ltd. (PINK:PRMRF) and Petroleum Development Company (NASDAQ:PETD) are all up over 100 percent.

But keep in mind: None of these stocks is a true “pure play” on natural gas. Northern Oil and Gas’ third-quarter production was made up of 96 percent crude and only 4 percent natural gas. Clayton Williams’ reserves, meanwhile, are 60 percent oil and natural gas liquids and 40 percent natural gas. So a substantial portion of these companies’ returns may in fact be due to their oil production, not their natural gas activities.

Another wrinkle for investors is understanding just how much of a company’s product is hedged, and at what price.

Companies hedge their future production to lock in favorable prices, but it’s also a way to inject a bit more stability and certainty into their bottom lines. Without hedging, companies are exposed to daily volatility and price swings that add uncertainty and risk into funding existing operations, not to mention any future capital improvements.

Recent low natural gas prices have not encouraged companies to hedge, as many firms are holding out for higher prices before they lock in. In fact, a recent Bloomberg article reports that many companies currently hedge only 30 percent of next year’s production, compared with 50 percent for this year’s production.

If these producers are unable to secure the higher prices they want, they may be forced to sell more gas at spot prices, which will directly affect their bottom lines. And the consequences will ripple out beyond that, as capital expenditures on drilling and development are reduced.

In fact, we may already be seeing this happen.

On Friday, Southwestern Energy (NYSE:SWN), issued a press release announcing they’d lowered their planned capital investment for 2011 to $1.9 billion from the $2.1 billion used in 2010. Not only has Southwestern Energy seen its share price plummet 20 percent over the past year, it is one of those companies set to enter the new year hedging a fairly low fraction of its future production—only 27 percent.

So while this year natural gas companies have benefited from waiting to lock in at least some of their production at higher than current prices, I expect to see a much different picture in 2011 if natural gas prices don’t pick up.

Written by Julian Murdoch From Hard Assets Investor (HAI) is a research-oriented Web site devoted to sharing ideas about hard assets investing. The site has been developed as an educational resource for both individual and institutional investors interested in learning more about commodity equities, commodity futures and gold (the three major components of the hard assets marketplace). The site will focus on hard assets investing without endorsing or recommending any particular investment product.

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