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"Nat gas is down under $2. Oil was $100. If a few years ago you told Charlie Munger or me that oil vs. natural gas would be 50:1 ratio we would have asked you what you were drinking."
– Warren Buffett, 2012 Berkshire Hathaway Annual Meeting.

With this quip at last weekend's Annual Meeting, Berkshire Hathaway CEO Warren Buffett highlighted an issue that energy investors have been pondering for a few years now: How are natural gas prices so low, and how long are they going remain this low? For some investors -- and I've heard some of my Foolish colleagues make this argument -- buying natural gas producers when the commodity is at a cyclical low looks like a good bet. While that may turn out to be the case, I'd be very careful before putting money on the felt to bet on a cyclical upturn in gas prices in an industry undergoing huge secular change.

What goes down, must come up
First, if you're not familiar with the concept of mean reversion, I like to summarize it as "what goes up, must come down, and vice-versa." When a price series is mean-reverting, it exhibits peaks and troughs that oscillate around an average value, which appears to exert a gravitational pull on prices that stray too far away. Inflation-adjusted natural gas prices appear to exhibit some measure of mean-reversion, according to a statistical test I performed on a monthly price series dating to 1960 (for the statistics wonks, the p-value was 6% -- not quite the 5% level of significance you typically look for, but pretty good all the same.)

If you graph those prices over the past 10 years, you can eyeball this phenomenon, as price increases alternate with declines with an average value somewhere between $5 and $10:

Sources: U.S. Energy Information Administration, author's calculations.

Sources: U.S. Energy Information Administration, author's calculations.

However, the tendency appears to break down at some point around 2008 and 2009, as prices remain lower, for longer than normal. What's happened since then? Why are prices depressed, and why haven't they recovered yet? The answer lies in the fact that the natural gas industry -- in the U.S., in particular -- is undergoing change that lies outside the bounds of cyclicality and threatens to upset the yardsticks investors have become familiar with. Here's a look at what's going on:

Source: U.S. Energy Information Administration.

Source: U.S. Energy Information Administration.

After a 30-year period of stagnation that began in the mid-1970s, the recent rise in gas production can't go unnoticed. Over the past five years, annual production has increased by a quarter, as a result of the development of new hydraulic fracturing ("fracking") techniques to release natural gas from shale and horizontal drilling. When the frack changes, I change my mind (apologies to Lord Keynes).

How much new supply do these advances create? One of the figures that crops up with alarming regularity -- from the Financial Times to Wikipedia -- is an estimate according to which the U.S. may now be sitting on a 100-year supply of natural gas. However, as Chris Nelder points out in an excellent piece in Slate, that estimate looks vastly inflated once you begin take a careful look at the data. But while hype isn't useful, it isn't any more useful to deny that the combination of fracking and horizontal drilling represent a "game-changer" that creates a structural, rather than cyclical, change in the economics of the industry.

Don't go fishing in shifting waters
I don't recommend stock-picking for individual investors unless they are highly committed to the craft (to a point that would qualify them as semi-professional) and they happen to enjoy it (life is too short). My injunction is even stronger with regard to trying to pick stocks in an industry undergoing structural change, the effects of which are often very difficult to predict -- even expertise provides little support. My guess is that natural gas prices can remain "depressed" longer than you can remain patient -- or solvent, if you're imprudent enough to invest on margin.

However, if I can't dissuade you from going down that road, of all the major natural gas producers -- including Cheniere Energy (NYSE: LNG  ) , Newfield Exploration (NYSE: NFX  ) , Apache (NYSE: APA  ) , Southwestern Energy (NYSE: SWN  ) , and Chesapeake Energy (NYSE: CHK  ) -- I wouldn't hesitate in looking at Chesapeake first.

Making smart bets
Indeed, the aberrant, well-publicized breakdown in governance at Chesapeake has cast a pall over a stock that still represents a fractional interest in some choice assets. A material change in attitude (or composition) of the company's board and leadership would lift the stock to reflect the value of those assets. To my mind, that's a better bet than trying to handicap the evolution of natural gas prices – especially when you have respected value investor Southeastern Asset Management on your side. As an alternative, if you're interested in the broader energy sector, you'll want to look at The Only Energy Stock You'll Ever Need.

Fool contributor Alex Dumortier holds no position in any company mentioned. Check out his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway and Chesapeake Energy. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (39) | Recommend This Article (91)

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 May 12, 2012, at 5:05 PM, rv1977 wrote:

    Thanks Aubrey. Now my kids can go to community college.Unless your puppet board member at OSU gives me a discount on tuition.

  • Report this Comment On May 13, 2012, at 12:42 AM, luremaster wrote:

    When Drake drilled the first oil well, it affected the price of oil for about 100 years. Could fracking and horizontal drilling lower the price of natural gas for years or decades? Long CHK.

  • Report this Comment On May 15, 2012, at 5:20 PM, oldgolfer32 wrote:

    Where doe Encana fit in this picture?

  • Report this Comment On May 15, 2012, at 5:27 PM, Midas5280 wrote:

    ...And Devon Energy? You've got to be joking if you think CHK is a "buy" with all its corrupt pratices.

  • Report this Comment On May 15, 2012, at 6:00 PM, andyinsandiego wrote:

    I was a little surprised that you suggested CHK was the best out of that group. Seems fly in the face of the whole "when there's smoke, there's fire" adage.

    Also Newfield is very aggressively selling off their Nat Gas exposure in favor of oil right now.

  • Report this Comment On May 15, 2012, at 6:04 PM, TMFAleph1 wrote:

    <<I was a little surprised that you suggested CHK was the best out of that group.>>


    I didn't say it was the "best" in that group, I said it was the first one I would look at, simply because, as I see it, it is the most highly likely to be mispriced.

  • Report this Comment On May 15, 2012, at 6:11 PM, bretco wrote:

    makes a grown man want to cry...................

    what about the methane problem pointed out in a recent MF feature ? What will the impact of that little problem do to the natural gas industry, Westport, Cummins and International ?

  • Report this Comment On May 15, 2012, at 6:11 PM, TMFAleph1 wrote:

    <<You've got to be joking if you think CHK is a "buy" with all its corrupt pratices.>>


    Any asset is a "buy" at the right price. The attitude that consists in refusing to look at Chesapeake because of the breakdown in governance is defensible, but it is that attitude that helps to create an opportunity for investors who *are* willing to analyze the risk and assess whether or not it is fully reflected in the price.

    Nothing wrong with being in the first camp; in fact, it's more appropriate for individual investors, most of whom don't have the time, knowledge or experience to analyze these risks. As I mentioned in the article, I don't recommend individual investors try to be stock-pickers in the first place.

  • Report this Comment On May 15, 2012, at 6:44 PM, PatentGamer wrote:

    What about backlash against fracking techniques? This analysis seems to presume that fracking will be allowed and will not meet resistance, but it is meeting significant resistance in at least one third of the major reserve areas (PA/NY Northeast).


    I would think this would have some impact? No?

  • Report this Comment On May 15, 2012, at 7:54 PM, Foolme2x wrote:

    A couple of points.

    Fracking isn't some new unknown technique. I inheirited an interest (very small) in a well that has been in production more than 50 years - it was fracked when it was put into production.

    If one is an investor, not a trader/speculator, what is most important is the basis for Buffet's comment. Currently, there is an irrational disconnect between the price of oil and the price of natural gas. On an energy equivalence basis, the ratio Buffet mentioned should be approximately 6:1. As is often said, irrationality can persist longer than any of us would ever imagine, but eventually it ends.

    Gas can be used just about any and everywhere that oil is used (and at some point in history, somewhere in the world, has been). Gasoline, chemicals and food ingredients can all be made from gas, just as they are from oil. In some specific applications, derivation of the desired product from oil is more efficient, in others gas is the better starting raw material. When done on large scale, in most cases it doesn't make much difference which is used. Eventulally, the price of gas must correlate with the price of oil, & vice-versa.

  • Report this Comment On May 15, 2012, at 7:58 PM, papsrus wrote:

    Characterizing what's going on at CHK as a "breakdown in governance" doesn't really capture the extent of the deceptive scheming that basically underpins the company, does it?

    No way I'd touch it.

    Also, the investment thesis for virtually any nat gas play at this point depends on a secular shift in consumption, not just production. Highlighting just one side of that equation fails to capture the whole story.

    best, Paps

  • Report this Comment On May 15, 2012, at 8:29 PM, woodNfish wrote:

    The Author states: "I wouldn't hesitate in looking at Chesapeake first."

    Wow. I mean just WOW! The ignorance displayed by this author is truly amazing. As stated earlier, fracking is nothing new. And Aubrey McClendon is a crook who is screwing his shareholders for his own advantage. He should be investigated by the SEC.

    Anyone who suggests investing in Chesapeake is a good idea does not deserve to be listened to and all their financial advice is suspect.

  • Report this Comment On May 15, 2012, at 10:34 PM, Chontichajim wrote:

    When a company takes out an unsecured loan to expand you hope the business will expand fast enough to justify the high interest. When a company takes out an unsecured short term loan 7% above prime (e.g. CHK) to pay debt you stay away.

    I prefer N Gas infrastructure since no matter who is doing the production they need to move the gas and I get the dividends. Long on WMB. Also bit on the N Gas to Propyline IPO last week.

  • Report this Comment On May 15, 2012, at 11:55 PM, TMFDarwood11 wrote:

    I wonder if the natural gas, which is now so inexpensive, could be used to power plants for producing very high quality gasoline, etc. derived from coal.

    At the current prices, it would seem feasible. That would have long term strategic interest for the military. Perhaps DARPA will get into the act.

    If this were China, with centralized planning, it probably would happen. Because this is the U.S. it is unlikely because our politicians prefer to obfuscate and avoid the important issues. However, with tightening military budgets, who knows?

    The technology was proven in the 1930s and into WWII by Germany.

    My point is that if natural gas is 1/50th the price of oil, and if it should remain so for a period of years and in abundance, then it is conceivable that there could be some very interesting energy developments.

    As an investor at this juncture, I simply can't predict how this will go, how long it will take, etc. That makes an investment speculative.

  • Report this Comment On May 16, 2012, at 12:47 PM, jargonific wrote:

    We desperately need alternative energy resources. Natural Gas especially that obtained through fracking, is not an alternative to the fossil fuel crisis. It's a disaster in the making.

    Ask people in Pennsylvania who have to live with the pollution in the air and water. It's a nightmare for them. Imagine worrying about the air and water making your children sick, or killing your parents as they get diseases caused by toxic air and water.

    I can't imagine how bad it would be, but it's got to stop. We're seeing a huge expansion, and that is very unwarranted given all that we know about the consequences.

  • Report this Comment On May 16, 2012, at 2:02 PM, TerryHogan wrote:

    Basically, what you're saying is "This time it's different"

    Sometimes it's best to take a contrarian position when people say that. See: tech bubble, mortgage backed securities ratings, JPMs enhanced oversight after 2008, end of the business cycle thanks to the feds deft management, etc. etc.

  • Report this Comment On May 16, 2012, at 3:34 PM, TMFAleph1 wrote:


    <<Basically, what you're saying is "This time it's different">>

    Yes and no.

    I'm saying the parameters of the mean reversion process have changed/ are changing, but I'm not calling into question the premise of mean reversion .

    In short, prices will very likely head higher at some point, but we shouldn't rely on the existing price history to estimate how long it will take, nor to what level they are likely to revert.

  • Report this Comment On May 16, 2012, at 6:24 PM, Wade32ru wrote:

    Nice read. The article that you site, "What the Frack", actually paints a bullish picture for natural gas in my opinion. The argument that we might not have as much nat gas as we think - this would imply a lower supply, which would eventually translate into to a higher price. The argument that natural gas exploration and development is not profitable - this will translate into industry consolidation (via acquisitions and bk) and producers raising their prices to become profitable. If anything, the takeaway from the article seems to be that nat gas prices will rise.

  • Report this Comment On May 17, 2012, at 1:02 PM, TMFAleph1 wrote:

    "Royal Dutch Shell expects US natural gas prices to double by 2015, rebounding strongly from the 10-year lows they have hit as a result of the shale gas boom as US domestic demand for the fuel grows."

    Shell Warns on US Natural Gas Bounce, FT, May 16

  • Report this Comment On May 17, 2012, at 1:45 PM, TMFAleph1 wrote:

    "In an interview, Shell chief executive Peter Voser said prices would remain under pressure in the short-term “but we would see a recovery . . . in the second half of the decade”.

    For planning purposes, he said, Shell was using a price of $4-$6 per million British thermal units for 2014-15, up from the current $2.55."

    Shell Warns on US Natural Gas Bounce, FT, May 16

  • Report this Comment On May 18, 2012, at 1:01 AM, Notfooled1 wrote:

    If TMFAleph puts any stock in statements by company presidents, he is a bigger fool than he appears to be.

  • Report this Comment On May 18, 2012, at 11:12 AM, homechickeninc wrote:

    Wow CHK huh.... I was driving past their corporate HQ yesterday with some friends who told me that the State of Oklahoma is thinking about bailing them out should it get that bad. My friend seemed quite upset as they employ a large amount of people here. I wondered why they were building so many buildings and not really caring to save any money on the acquisitions of the land they were buying.

    Now we have Devon with a giant phallic symbol downtown like it has to compete with the silliness of CHK's constant campus expansion.

    If I had the money I would go with the relatively new company continental even though I currently own DVN.

  • Report this Comment On May 18, 2012, at 11:20 AM, ziq wrote:

    It would be f-oolish to ignore the controversy over the possible environmental effects of "fracking", and pressure for legislation to control or outright ban it--and I mean purely from an investment point of view. But this article seems to. If the producers get their way in court (possible Fifth Amendment "taking" cases, I don't know how claims that environmental regulations represent seizing of property without compensation have gone in the past) and in the legislatures it will be one thing, but if not, it could be a game changer changer.

  • Report this Comment On May 18, 2012, at 11:21 AM, petehanse wrote:

    IMHO the absolute BEST natural gas stock out there for long term growth is LNG!

  • Report this Comment On May 18, 2012, at 11:59 AM, Rborlick wrote:

    One talking head on CNBC (Cramer?) has suggested that CHK may be another ENRON waiting to happen.

    I wouldn't touch this stock because of all the behind the scenes shenanigans that have taken place between the Board and the greedy, reckless, self-serving CEO who don't care about screwing over their own shareholders.

  • Report this Comment On May 18, 2012, at 12:09 PM, ROKSlide wrote:

    Not understood by virtually all analysts is the fact that 90 percent of the horizontal gas wells drilled to date will not payout. At sub-$2.50 per MCF, these companies will be lucky to get 1/2 their investment back on the average well. Legal but misleading accounting practices allow them to book all costs into a pool that is depreciated as reserves are produced, but reserves are added for yet-to-be-drilled wells that are uneconomic in sufficient amount to defer the write-offs that will ultimately sink many of these companies. Buyer beware!

  • Report this Comment On May 18, 2012, at 12:13 PM, dbamity wrote:

    jargonific - Getting tired of liberal environmentalists using these investment sites to spout off-base anti drilling rhetoric. You say to "ask people in Pennsylvania who have to live with the the air and water pollution, sick children, diseased and dying parents, etc." Well, ask away - I live in the heart of the Marcellus drilling and see virtually NO significant environmental impacts. Sounds like you have bought into the Josh Fox nonsense. And zig - I agree that it would be foolish to ignore the controversy around environmental issues, but one by one they are being soundly debunked and will continue to be shown to be little more than environmentalists attempts to eliminate hydrocarbon development in general. The recent elevation of air quality issues is simply a pivot by the left to a new scare tactic due to the steady stream of revelations (Pavilion Wyoming, Dimmock, PA, etc.) that verify the environmental soundness of the fracking process.

  • Report this Comment On May 18, 2012, at 12:31 PM, jimwattx wrote:

    a question will the pipelines/transporters have any protection - vis a vis the operators ????

  • Report this Comment On May 18, 2012, at 2:58 PM, TENOFWANDS wrote:

    Natural gas is transitioning to a MAINSTREAM FUEL OPTION for ordinary cars, and, especially, municipally regulated businesses such as TAXIS. This is driven (sorry for pun) by environmental AND economic issues. One can expect that natural gas development will, in the near and mid-term, BE HEAVILY SUBSIDIZED relative to coal, oil, and nuclear. It WAS a cyclical; it will one day again be a cyclical with a different periodicity; in the transition, it will be ANYTHING BUT CYCLICAL.

  • Report this Comment On May 18, 2012, at 3:36 PM, 619bell wrote:

    How do companies like Westport wprt and nov fit into this picture of low gas prices?

  • Report this Comment On May 18, 2012, at 3:48 PM, dokodesuka wrote:

    You may have missed the obvious point about current natural gas prices. As folks, typically, over-invested in the big new shale gas opportunity, encouraged by high prices when those decisions were made, we got a big increase in supply but no increase in demand in the US. What about oil, or natural gas liquids? Supply for these has gone up a lot, too. How come prices have held up there? That extra supply reduces expensive imports. Not so with natural gas. We don"t import much at high prices. We can't export much due to lack of facilities ... so far. Folks who are looking at investing to take advantage of all this new gas are considering the same sort of prices as Shell has quoted.

  • Report this Comment On May 18, 2012, at 5:34 PM, SocialRespInvest wrote:

    Since the earth under our feet is full of cracks and fractures, what keeps them from slipping past each other?


    So it does not seem very bright to fill the cracks with slippery fluids under high pressure. Anyway, many of us who felt the rare VA earthquake up and down the East Coast have come to recognize that the burden of proof should be on those who say, "don't worry, just a coincidence".

  • Report this Comment On May 18, 2012, at 6:05 PM, flashdonsr wrote:

    rig count for Nat gas continues to drop.

    Rig count for oil continues to go up.

    This will adjust the supply problem.

    Nat gas has gone from 1.90 on April 19 to

    2.60 today. A sizable per annum increase in

    about 30 days. Futures market expects more

    increases with either a hot summer or cold winter.

  • Report this Comment On May 19, 2012, at 2:05 AM, piinob wrote:

    Lots of noise here. NG is going to play a significant part in the future energy needs of the USA. There are very real environmental concerns, no doubt about it. I have seen them all my life here in Texas. States will get a grip on which rules and regs are effective and not overly burdensome just as we have for the last 75 years or so. The little earthquakes are going to happen. You cannot remove all the volume from under the ground and leave it to hang in mid air. Physics is still physics no matter what anyone says. But we will get around these things because we want the payoff.

    Anyone who doesn't see the need for reasonable protections here has no experience with these events happening in their neighborhood. The majors are pretty responsible, but some of these drillers will do whatever they can get away with and don't care one bit who they hurt.

    Anyone who doesn't see the opportunity here needs to go find something else to do.

    Good article.

  • Report this Comment On May 20, 2012, at 12:29 PM, MrMarcus65 wrote:

    dokodesuka - so you're a geologist/geophysicists? You do realize that the plates that we're living on are in constant motion, right? And, that this constant motion has been causing earthquakes looooong before the concept of 'fracking' was first introduced?

  • Report this Comment On May 20, 2012, at 3:50 PM, ronel327 wrote:

    THE ARTICLE says you may not live long enough

    to benefit from this energy source but CHK will

    be profitable and I agree.

  • Report this Comment On May 20, 2012, at 3:51 PM, stefaith wrote:

    It is certain that current prices for NG will accelerate the pressure to find new markets, either by exporting liquified NG or using it domestically as a fuel for vehicles, and forgenerating electricity. These trends are under way, the question is only how long it will take.

    Anyone investing in companies that are drilling for NG will have to be patient

  • Report this Comment On May 20, 2012, at 8:46 PM, woodNfish wrote:

    "On May 18, 2012, at 11:20 AM, ziq wrote: It would be f-oolish to ignore the controversy over the possible environmental effects of "fracking""

    Actually Ziq, you and the rest of the people who are concerned about this don't know what you are talking about. There are no environmental concerns. Water aquifers are only hundreds of feet deep and gas wells are thousands of feet deep, there is NO interaction.

    This "environmental" controversy is being driven by people who want to shut down energy production in this country. This has nothing to do with the environment and everything to do with money and control and the destruction of our economy by commies.

  • Report this Comment On May 28, 2012, at 6:41 AM, thidmark wrote:

    I wouldn't buy a loaf of bread from Aubrey McClendon, no matter how "cheap" that loaf may appear.

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