Discover Royal Returns in Natural Gas

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While the investment world clamors and claws for natural gas exposure, the well-informed Fool drills deeper into the space for the path less traveled.

Natural gas prices dipped to a seven-year low last week, beneath $3 per MMBtu, even as oil retained strength above $70 per barrel. While a barrel of oil has historically equated in price to between 6 and 12 times that of natural gas, this relationship has now reached a crude extreme of 24.5 to 1. Seasoned energy traders know that something has to give.

Bullish indicators for a looming price recovery have gained clarity even as prices have continued to deteriorate. Undoubtedly, it will take time to absorb the 3.2 trillion cubic feet of available product presently in storage (19% above the five-year average), but bullish longer-term indicators include:

Future shock
Futures reflect a clearly bullish sentiment, projecting $5 natural gas by December 2009, and moving above $6 for the October 2010 contracts. Before you ponder diving into futures, however, consider yourself Foolishly forewarned: The market for natural gas futures appears far from natural at the moment.

With more than 40 million shares changing hands daily, United States Natural Gas Fund (NYSE: UNG  ) has seen no shortage of interest from investors trying to time a bottom in natural gas. Unfortunately, in their collective stampede they created an untenable condition, whereby the fund holds some 30% of the futures market, potentially distorting natural gas prices as it rolls contracts. The fund trades at a double-digit premium to its net asset value, has shifted some assets away from futures into unregulated over-the-counter derivatives, and in short, cannot be considered a safe investment vehicle.

The storm before the calm
Fellow contributor Toby Shute is my go-to Fool for insights into the natural gas space, and his expectation for still-lower natural gas prices is based upon well-researched observations of supply-and-demand dynamics. When Toby points to producers like Chesapeake Energy (NYSE: CHK  ) and XTO Energy (NYSE: XTO  ) keeping the gas flowing, even while projecting forced curtailments by storage providers like Kinder Morgan (NYSE: KMP  ) , Fools are advised to take note.

Between possible reverberations in the futures market from the ailing futures ETF, and the aggressive production stance of key producers in the face of massive stored supplies, the potential for further near-term price weakness to precede an eventual long-term recovery appears entirely plausible.

Natural choices for investors
Investors looking to profit from an eventual natural gas recovery may not have as many compelling options to choose from as they might expect. In addition to troubles with the futures ETF, shares of producers like Chesapeake Energy have rallied impressively from their 52-week lows, moving in the opposite direction of the underlying commodity price for several months running.

What we have here, Fools, is a crowded trade. I believe investors have been catching a falling knife for months, building downside risk into related equities that could manifest as this acute oversupply condition continues to unfold. Under such circumstances, I seek scour a sector for high-quality, overlooked equities with an income boost to help absorb some potential downside.

I recently highlighted midstream operators like Kinder Morgan and Energy Transfer Partners (NYSE: ETP  ) as solid choices, but even these lesser-known names are not the overlooked industry laggards I seek. For my latest pick, I dug a horizontal well clear into Canada.

The royal flush of royalty trusts
I have owned a basket of Canadian energy income trusts, with Enerplus Resources Fund (NYSE: ERF  ) among them, since the Halloween Massacre of 2006 decimated shares with a new tax structure to take effect in 2011. I consider the entire group relatively overlooked, including even large-cap offerings like Penn West Energy (NYSE: PWE  ) .

With natural gas representing 60% of production, Enerplus Resources Fund is this Fool's top choice for natural gas exposure. The company pays a monthly dividend with a nearly 10% annualized yield, and has committed to retaining its income-oriented structure even after converting to a non-trust corporation late in 2010. Thanks to an effective hedging program, the company recorded only a slight loss of $3.3 million.

Enerplus boasts an attractive debt to trailing 12-month cash flow ratio of 0.7, and a conservative payout ratio of just 43%. Meanwhile, with a 22% increase to reserves at the Kirby oil sands project, and a key acquisition of natural gas acreage in the promising Marcellus shale, I consider Enerplus well-positioned for a prosperous future. Meanwhile, the stock has been a notable laggard in 2009 compared with all the operators noted above.

Fewer than 600 of the nearly 140,000 investors at Motley Fool CAPS have added Enerplus Resources Fund to their CAPS portfolios, though 96% of those picks were bullish. I've cast my vote, have you?

The "natural gas" tag within the Foolish universe of Motley Fool CAPS lists 57 ways to invest in the space. Join the CAPS community to discover which gas plays burn brightest. It's free and fun!

Fool contributor Christopher Barker reminds Fools to avoid campfires in the vicinity of any pipelines. He can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets. He owns shares of Penn West Energy Trust and Enerplus Resources Fund. Chesapeake Energy is a Motley Fool Inside Value selection. The The Fool owns shares of Chesapeake Energy and XTO Energy. Try any of our Foolish newsletters today, free for 30 days.

Read/Post Comments (5) | Recommend This Article (32)

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 August 26, 2009, at 11:59 AM, bothisellhigher wrote:

    I would agree on Kinder if it ever cracks resistance of about 55...but only because it has a decent dividend...I doubt though that this resistance will be taken out soon. Same could be said for Energy Transfer above 43 I guess...but really, we're dealing with not only "down the road" plays but pretty boring stuff-if you're going to wait awhile-wait for gold I say.

  • Report this Comment On August 26, 2009, at 12:07 PM, animaha wrote:

    Yahoo Finance shows ERF to have a payout ratio of 85%. How did you arrive at the 43% figure??

  • Report this Comment On August 26, 2009, at 1:19 PM, silverminer wrote:


    I find incorrect data within online stock listings quite frequently. It always pays to check from the ultimate source: a company's earnings-related filings. ERF's filing for second quarter earnings provides a payout ratio of 43%, and an adjusted payout ratio of 61%.

    From page 17 of the press release:

    "Our payout ratio, which is calculated as cash distributions divided by cash flow, was 43% and 47% for the three and

    six months ended June 30, 2009 respectively, compared to 56% and 64% for the same periods in 2008. The

    decrease in our payout ratio is due to the reduction in our monthly cash distributions along with fluctuations in our

    working capital balances that impact cash flow. Our adjusted payout ratio, which is calculated as cash distributions

    plus development capital and office expenditures divided by cash flow, was 61% for the second quarter and 83% for

    the six months ended June 30, 2009. See “Non-GAAP Measures” above. Our reduced capital spending levels

    combined with decreases in our non-cash operating working capital in the second quarter has reduced the second

    quarter adjusted payout ratio to 61% from 112% in the first quarter of 2009. We expect to support our distributions

    and capital expenditures with our cash flow over the remaining quarters in 2009, however, we may fund acquisitions

    and growth through additional debt and equity if required. We continue to have conservative debt levels with a debt

    to trailing twelve month cash flow ratio of 0.7x at June 30, 2009 and a debt to annualized year-to-date 2009 cash flow

    ratio of 1.1x."

  • Report this Comment On September 07, 2009, at 11:50 AM, ajbegany wrote:

    I've owned ERF since 2005 and just bought more. Its monthly payout covered my car payment from 2005 - 2008. Yes, they had to cut their payout early this year, but when natural gas prices rebound investors will be happy with the increase in share price. The monthly payout may never get back to the glory days of the CANROY era before the Halloween Massacre, but investors will certainly be rewarded on the share price side in a corporate structure. ERF is a bargain under US $25.

  • Report this Comment On October 04, 2009, at 8:03 PM, 1caflash wrote:

    ERF is a terrific ground-floor investment! Use volatility as a friend; buy this gradually on the dips. In Riverside County, California U.S.A., it is a pleasure following an R.T.A bus, except you still can't see around them. Sure beats Diesel!! When smart folks realize Natural Gas can benefit us more than it is being used, then ERF, PWE and similar High-Yielding Shareholder friends will continue to improve, and your financial picture also will. The Canadian government may have done us a favor by forcing these companies to GROW!!! In YOUR PORTFOLIOS, YOU don't want Stagnation!!!

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