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The Wrong Way to Bet on a Natural Gas Recovery

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Natural gas has plummeted to its lowest levels in a decade. Although low prices for natural gas are causing problems throughout the energy industry, contrarian value investors look at the plunge as a potential buying opportunity.

Yet before you put your hard-earned money into one of the most obvious plays in the natural gas space, you need to do your due diligence. Once you do, you'll find that a huge coming spike for a popular natural gas ETF isn't what it might appear to be at first glance -- and longer term, you could find yourself disappointed if you invest in it.

I'll talk about that exchange-traded fund ETF later in the article. But first, let's review where natural gas is -- and where it could be headed.

The bull case for natural gas
Few people could have foreseen the huge rise in natural gas production over the past several years. Unconventional energy plays like shale gas have greatly expanded supply well beyond what the market was prepared to see. For instance, in a typical month, Cabot Oil & Gas (NYSE: COG  ) produced almost 55 Bcf of natural gas from its Pennsylvania Marcellus shale holdings alone. As a result, demand hasn't kept up at all, and prices have had nowhere to go but down.

But now, companies are finally starting to take steps to curtail supply. Chesapeake Energy (NYSE: CHK  ) has shifted production away from dry gas and plans to continue doing so, with asset sales designed to raise cash. Even low-cost producer Southwestern Energy (NYSE: SWN  ) is making similar moves, observing that gas rig counts are falling sharply and capital budget reductions are likely to follow suit. Only the absolute lowest-cost companies can afford to keep producing at these levels, as Ultra Petroleum (NYSE: UPL  ) has done, expecting to continue ramping up its gas output even at current prices.

The ETF for you?
If lower supply leads to higher prices, then the first place many people would look for profits is the U.S. Natural Gas Fund (NYSE: UNG  ) . Unlike many funds that own shares of companies in the energy industry, this ETF has direct exposure to natural gas prices through futures contracts. On any day when gas futures rise, you should expect to see its shares go up, too.

In fact, I can just about guarantee that U.S. Natural Gas will see its share price quadruple later this month. But that's not because I expect natural gas to jump from $2.50 to $10 -- but rather because of something we've unfortunately seen before from this ETF.

Doing more splits
Starting next Wednesday, U.S. Natural Gas will trade at four times its closing price the night before as a result of a 1-for-4 reverse split of its shares. So if you own 100 units of the ETF at $5 next Tuesday night, you'll wake up the next morning with 25 units worth $20 apiece. As you can see, the total value of your holdings will stay the same, as you'll simply have fewer shares with a higher price.

U.S. Natural Gas did a 1-for-2 reverse split less than a year ago, coincidentally again when the share price had hit the $5 level. The move bumped the shares back to double-digits for a while before they fell back, losing more than half their value since last March.

That may make sense given the drop in gas prices. But looking back further, the ETF has lost more than 95% of its value in the past five years. That's quite a bit more than the drop in gas prices from between $7 and $8 to their current levels around $2.50, and it stems from something called contango: the way gas futures markets are positioned.

I've described contango before, but to look at it from another perspective, look forward in time. Futures contracts for next year expect gas prices to rise almost 50% to the $3.60 to $3.70 range. If you invest in this ETF hoping for a 50% gain if that price recovery comes to pass, you won't get it -- in all likelihood, you'll get flat performance at best, because the rise will all get eaten up by the friction of trading in and out of monthly futures contracts along the way.

Look elsewhere
ETFs can be useful tools for investing, but only if they work the way you expect. With the U.S. Natural Gas ETF, the futures markets prevent the fund from doing its job over the long haul. You'll be better served looking for more direct beneficiaries of a gas recovery if you want to profit from it when it comes.

If you like energy plays, we've got a much better bet. Read about it right here in the Motley Fool's special free report on the energy industry and its best prospects -- it's free, but only available for a limited time.

Fool contributor Dan Caplinger likes ETFs that do their job right. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Ultra Petroleum. Motley Fool newsletter services have recommended buying shares of Ultra Petroleum 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 Fool's disclosure policy never saps your energy.

Read/Post Comments (4) | Recommend This Article (15)

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 February 16, 2012, at 2:09 PM, botfeeder wrote:

    The way I've decided to play natural gas:

    Buy out of the money call options on the best natural gas stocks.

    Mainly I have gotten some Jan 2014 calls on CHK at strike prices of $30-45.

    The natural gas glut could go on a long time. These companies are no longer able to do much hedging. When their old hedges run out they could show some pretty nasty financials; I'm not confident their liquids production will save them.

    So I am hesitant to own the stocks outright. The bloodbath could just get worse.

    But I don't want to miss out if there is a recovery in NG prices. Maybe the slowdown in gas drilling and a bout of cold weather next winter or the following winter will firm up gas prices.

    Since I believe the long term value of a company like CHK is way higher than it is right now, I don't want to miss out if and when the recovery happens.

    In a bull market I could easily see CHK up to $70-100 per share.

    By gambling a few bucks on call options you assure that you don't miss out if that happens. Most likely I will lose most of what I put in those call options. That's OK. I'm only taking options on about the same number of shares I would own outright if I weren't worried about further downside.

    I won't get rich by this strategy but I will guarantee I don't miss out on the investment gains if US natural gas has a renaissance.

  • Report this Comment On February 16, 2012, at 8:42 PM, Edeskimo wrote:

    CHK's long-term value is mostly in its oil land assets right now.

    Most of their current revenue, however, comes from their natural gas wells that have already been drilled.

    I really don't have too much issue with going long on CHK because I am buying the land assets much cheaper than is available on the market and the public is still locked into valuing it by its natural gas production. Thus we have a classic case where Mr. Market has mispriced a company.

    I partly believe the company may be most profitable by selling its land assets to major oils with some sort of a royalty agreement attached and then folding up by the operational side and just have the company deliver royalties to the shareholders.

  • Report this Comment On February 17, 2012, at 11:30 PM, inmocean wrote:

    Talk about timing - I was just espousing this method of riding a long term trend to my son. I said that here was a trend (UNG) that had gone on for 10 years, so it would eventually form a base and then head up for years. But I would have paid a price for my lack of FOOLishness. "Thanks, half-pint, you just saved me a lot of detective work."

  • Report this Comment On February 18, 2012, at 12:26 AM, talotu wrote:

    "but to look at it from another perspective, look forward in time. Futures contracts for next year expect gas prices to rise almost 50% to the $3.60 to $3.70 range. If you invest in this ETF hoping for a 50% gain if that price recovery comes to pass, you won't get it -- in all likelihood, you'll get flat performance at best,"

    This is the closest I've seen to an actual description of what's at work. Contango isn't the major reason why UNG has lost so much value, the reason is because the futures market expected gas prices to go up and they ended up going the other direction.

    UNG isn't designed to track the spot price of natural gas, it's designed to track the near month futures price (which it does quite well). The problem is that in almost every month for the last 3 years natural gas futures have priced in a small to medium gain every month, and the price has sunk.

    2 years ago UNG traded for an adjusted 18.43 and the January 2012 futures were 7.50.

    Today natural gas trades for 2.50ish (a 67% decline over what the expectation was) and UNG is at 5.61 (a 69% drop).

    That means cost of carry contributed about 2% (or only 3% of the total drop) and the other 67% was by the overestimation in the futures.

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