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A Natural Gas Recovery Is a Pipedream

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Despite a recent rally, natural gas has fallen so far that experts and Fools alike are calling for a recovery. But like a stock, just because a commodity is down doesn't mean it's going to go back up.

I've been hearing that natural gas is set to bounce back for years as the gap between natural gas and the price of oil has widened. But who cares? There's no good reason that natural gas and oil prices should be linked. They're used for completely different things, and the storage and supply dynamics couldn't be more different.

So let me outline a few things you may want to consider before making a bullish bet on the price of natural gas.

More natural gas than we can use
Low demand hasn't helped the price of natural gas recently, but extremely high supplies are the real driver of the long-term price drop.

There has been so much supply recently that Chesapeake Energy (NYSE: CHK  ) is cutting production by as much as 1 billion cubic feet per day. But that hasn't stopped everyone else from increasing supply. Range Resources (NYSE: RRC  ) increased its proved reserves by 14% and said it replaced a whopping 850% of 2011 production.

With 141 trillion cubic feet of gas estimated by the U.S. Department of Energy to be recoverable, there's more natural gas than we can use and production isn't stopping anytime soon.

The marginal cost conundrum
Marginal costs are the costs associated with the next unit of production. In the case of the current leaseholds in the U.S., it doesn't matter if the natural gas price is so low that overall companies will be operating at a loss, what matters is whether the cost of producing the next cubic foot of natural gas is higher or lower than the price of natural gas.

Leases vary state-to-state and property-to-property, but many leases include upfront payments and limited time to drill on the land. That means there's a sunk cost associated with not drilling for natural gas producers and the marginal cost is much lower than the overall cost.

So producers have incentive to keep producing natural gas even though the price may be so low they're operating at a net loss.

This will also affect prices in the future. If the price of natural gas rises, more wells will become profitable on a marginal basis and more natural gas will hit the market, pushing the price of natural gas down.

Essentially, there's limited upside unless the supply/demand balance changes dramatically.

Too many competitors
There are also too many competitors in the natural gas business who need to produce product just to stay in the game. ExxonMobil and Chesapeake are big enough to adjust production and remain profitable, but others aren't.

Quicksilver Resources (NYSE: KWK  ) has been punished in the past year because of low prices and has struggled with a pile of debt. Most natural producers also have oil exposure and pure plays haven't performed well given the price of natural gas. Even Chesapeake is trying to increase its liquids exposure because it's afraid the natural gas business will remain a weakness.

How to make money from cheap natural gas
If you're going to play natural gas, I would look at companies that will benefit from low prices, not companies that need the price to rise to remain profitable. Clean Energy Fuels (Nasdaq: CLNE  ) is one of the companies that will leverage the low price of natural gas to provide lower-cost fuel to trucks and commercial vehicle fleets.

And if the fuel is cheap, we need a way to build natural gas vehicles, which is where Westport Innovations (Nasdaq: WPRT  ) comes in. The company provides the technology to build and convert engines to run on natural gas. By partnering with companies like Cummins and others, the company will be a big winner in a natural gas society.

Remember that just because something goes down, doesn't mean it has to come back up. I think there are plenty of reasons to believe that natural gas will remain depressed for the long term, something to consider when you're picking natural-gas-related stocks.

Whether you're betting on natural gas or oil, there's one company our analysts have identified as a great stock to own. We reveal the company in a free report called "The Only Energy Stock You'll Ever Need."

Fool contributor Travis Hoium does not have a position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings, or follow his CAPS picks at TMFFlushDraw.

Motley Fool newsletter services have recommended buying shares of Cummins, Range Resources, Westport Innovations, and Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (10) | Recommend This Article (27)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 26, 2012, at 4:02 PM, iswhatitis wrote:

    Actually, I'm not sure what position MF takes. Maybe their own. Day trader can take a view of today's price as an indicator. This segment is the future. Pieces coming together. Its the Apple of energy. I'm taking my byte. Sell low I'll buy!

  • Report this Comment On January 26, 2012, at 5:31 PM, pfxg99 wrote:

    Don't forget Chart Industries (GTLS) as a play on cheap natural gas

  • Report this Comment On January 26, 2012, at 7:34 PM, ershler wrote:

    You didn't even talk about the only reason natural gas prices may not rebound. If unconventional natural gas production in other parts of the world increases like it has in the US. In a few years we will be exporting enough natural gas to raise prices in the US if that doesn't happen.

  • Report this Comment On January 27, 2012, at 12:33 AM, lowmaple wrote:

    not being a geologist is there a good chance there is not another large nat gas supply under other countries in the globe?

  • Report this Comment On January 27, 2012, at 1:56 AM, BBLBBD wrote:

    Who would have thought that a supply of a material and the demand for that material would have an effect on the cost of that material ?! Wow...mind is blown over this supply and demand deal...does anyone else know about this ?

    The thing to look at is the big picture here, if the green lobby will allow it happen.

    In the short term: heating bill, hot water bills, all go down; gas appliances become more popular..stoves, dryers, ovens, fireplaces. Even if the mild winter did not play a role, these household cost will go down. Electricty (coal) will become less popular.

    Longer term: the trucking industry figures out that using natural gas powered trucks is cheaper than diesel fuel. Once the trucks use it, then soon it will go to private cars. The electric (coal) car will finally be seen as the folly that it is.

    Longer Longer term: the natural gas resources are as abundant and accessible as believed, then we are looking at entirely new world. Oil, coal will become niche industries. New companies and technology will grow to get the natural gas infrastructure could be the next step up. If the supplies are not there, then we have a minor alternative energy supply, like hydroelectricty.

    Probability: government intervention from bought off politicians, crony capitalism, "green" lobby (anti-progress, anti-American, anti-human), and general anti-Western Civilization sentiment will kill this in its tracks, will make it too expensive and difficult to pursue.

    Wish: Just give it a shot. Let's go for it. If is doesn't work, we will figure something else out. If it harms the environment, we will fix it like we did before. Get government "policy" out of the energy business (and all business for that matter), and let's see what happens

  • Report this Comment On January 27, 2012, at 2:44 AM, trek790 wrote:

    @lowmaple, exploring for nat gas recoverable by fracking (ie. shale gas) in other parts of the world is only just beginning. The only thing stopping the world from being flooded by such new supplies are regulatory issues.

  • Report this Comment On January 27, 2012, at 9:42 AM, olddogfb wrote:

    Hoium is spot on, in my opinion

  • Report this Comment On January 27, 2012, at 11:42 AM, mountain8 wrote:

    Long term investment.

  • Report this Comment On January 28, 2012, at 10:16 AM, btukwh wrote:

    Essentially, there's limited upside unless the supply/demand balance changes dramatically

    This is the core of why gas prices will rise. There is a revolution going on in power generation. Coal plants are being shuddered and natural gas fueled combined cycle plants are replacing them.

    There is a very short cycle time from concept to commercial operation for combined cycle. Maybe not next year, but in the following years we will see an exponential growth in gas consumption. The quickest way above $5 nat gas is to convince the utilities it will stay low forever. They are convinced.

  • Report this Comment On February 01, 2012, at 12:11 AM, MHedgeFundTrader wrote:

    Natural gas finally got some good news last week. First, major producer, Chesapeake Energy (CHK) announced that it was cutting its natural gas production by 50%, taking some immediate pressure off the market. Sure, (CHK) is just one company, but others may follow suit.

    Second, at the urging of my friend, Boone Pickens, Present Obama announced funding of some natural gas corridors in his State of the Union address. These are chains of natural gas stations placed every 100 miles stretching from east to west and north to south that would allow heavy trucks on transcontinental routes to refuel. This would provide the extra incentive for these 18 wheelers to convert from diesel fuel to CH4 at a nominal cost and put a major dent in our oil imports.

    The news was enough to trigger a massive short covering rally in this most unloved of molecules. The spot market soared 25%, from $2.25 to $2.82 per MBTU’s, while the ETF (UNG) leapt from $5 to $6.

    I am going to call the bluff of the market here and buy the United States Natural Gas Fund April, 2012 $6 puts at $0.65 or best. That way I can take advantage of the huge contango that exists between the spot and forward markets for natural gas futures contracts. To avoid actually drilling its own wells, the (UNG) buys forward contracts at huge premiums and holds them until they expire at spot. They then roll the cash forward into new contracts and repeat the process. It is one of the best wealth destruction machines I have ever seen and explains why (UNG) has, by far, outperformed natural gas on the downside. It is a great thing to be short.

    The Mad Hedge Fund Trader

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