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:
- Some stabilization of U.S. domestic industrial activity
- An abrupt reduction in the total number drills operating in the sector
- A palpable move by utilities to burn less coal in favor of cheaper natural gas
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?
