Arbitrage is a financial concept that's been around since the dawn of the time.
Simply put, engaging in arbitrage means buying an asset in one location where it's cheap, then immediately turning around and selling it in a place where it commands a higher price.
With globalization and international trade continuing to play a larger role in today's economy, arbitrage opportunities are getting harder to find... and even when you do spot them, chances are they won't last long.
Yet despite the rarity of these occurrences, this is exactly the kind of opportunity we're seeing in today's natural gas market...
Dave Forest - StreetAuthority's resident commodities expert and Chief Investment Strategist for Junior Resource Advisor -- is so excited about this opportunity that he recently dedicated an entire issue of his premium newsletter to covering it. Said Dave in his November issue of Junior Resource Advisor:
The current situation in natural gas markets is unique. As I write these words, U.S. and Canadian natural gas sells for a paltry $3.50 per thousand cubic feet (Mcf). And yet just across the Pacific in markets such as Japan and Korea, gas is going for nearly $16 -- as measured by the JKM Marker price for liquefied natural gas shipments to these countries.
That kind of geographic price discrepancy is unprecedented in the modern natural resources business.
Given how good people are at moving commodities to take advantage of price discrepancies, it's striking that natural gas markets could be laboring under such a massive regional disconnect. No other good today is in such a predicament. Almost all others have a price that is more or less global.
To be fair, there is a reason for the price discrepancy. Shipping natural gas is a tricky process. It needs to be liquefied and condensed before it can be transported. Then, once it arrives at the destination, it needs to be regasified so it can return to its original state.
As it stands, the United States currently lacks the infrastructure to export large volumes at an economical price. Consequently, most of the gas we produce ends up getting consumed here at home rather than packed up and shipped abroad.
But the arbitrage opportunity in the natural gas market is starting to garner considerable attention from American energy companies. For example, Cheniere Energy (NYSE: LNG) has been working on a natural gas export terminal in Louisiana for the past few years. Freeport LNG -- one of ConocoPhillip's (NYSE: COP) major partners -- is also working on an export terminal after it received a federal permit allowing the company to sell natural gas overseas in May.
All the efforts to move U.S. gas abroad hints at a major investment opportunity in this sector. As Dave went on to say in his issue:
In the U.S. exploration and production sector today, producers are being valued on expectations of a $4 natural gas price.
If gas were to rise to even $6 (still low by global standards), it would cause of flurry of upward revisions to valuations. (Not to mention a rush of investor excitement that could take valuations to more manic levels -- making significant profits for early-in investors.)
Now imagine if U.S. natural gas were to revert to average global prices. Maybe not the $15 we saw in 2006, but, say, $10 (which is probably around the global average for the developed world).
Such a move would represent one of the biggest price increases seen in the commodities space recently. Copper would have a hard time gaining 150% from current levels. I doubt even gold has the juice for such a move. But with natural gas, triple-digit price increases are entirely possible.
Now if you're interested in investing here, there are several ways you can play this trend. For one, you could start by buying companies with considerable investment in shale assets. These are stocks like Chesapeake Energy (NYSE: CHK) and Range Resources (NYSE: RRC) -- both of which control prime acreage in some of the country's top-producing shale fields.
But as we mentioned before, rising production costs are starting to weigh on the economic viability of companies with heavy shale exposure. Since most of these companies are already trading at lofty valuations, an uptick in natural gas prices might not be enough to offset the increase in costs.
Instead, a better way to invest in this trend would be to focus on companies with conventional dry gas production -- especially in areas like the Gulf of Mexico. Since these offshore regions are generally viewed as boring and outdated, they've been spared most of the attention that's engulfed onshore producers.
Specifically, Dave recommends companies like EPL Oil & Gas (NYSE: EPL) and PetroQuest Energy (NYSE: PQ), both of which derive a considerable amount of their production volumes from their offshore gas reserves.
What's more, if you're willing to invest outside the U.S., you could consider a stock like Encana (NYSE: ECA) -- the largest producer of natural gas in Canada. Since Canada's pipelines are tightly connected to those in the U.S., Canadian producers benefit from an increase in U.S. natural gas prices.
However, if you are thinking about investing, it's important to note that it could be a while before the U.S. has the infrastructure in place to ship large quantities of natural gas overseas. Based on current projections, Cheniere's export terminal isn't expected to be done until 2015... Freeport's won't even get started until the first quarter of 2014. As a result, natural gas stocks could remain depressed for a while.
But that said, the price discrepancy in the natural gas markets can't last forever. As export terminals come online and domestic producers start to take advantage of higher prices overseas, it could spur a significant rally in the sector. If that happens, chances are you'll be wishing you had bought U.S. natural gas companies when they were still hated.