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Thursday, December 26, 2013 - 08:30

It's Time For A Reality Check For Natural Gas

Thursday, December 26, 2013 8:30 AM

The stock market rarely gives you a chance to prove your investment thesis in real-time. Expectations for share price moves usually take many quarters to play out, if not longer. Yet a recent set of events has opened a window to provide a simple test for a recent suggested trading strategy.

Nearly two months ago, I noted that the early snowpack in Siberia was an accurate predictor of colder-than-usual weather in the United States. And that would have a profound effect on natural gas prices as consumption increased.

That part of the thesis played out like a charm. It's been quite cold in much of the eastern United States, which led to a faster-than-expected drawdown in gas storage. And that has led natural gas prices to quickly spike.

In that column, I recommended three companies that had an inordinately high exposure to gas, relative to most oil and gas producers. How have those stocks fared? Decently, but not nearly as fast as the underlying commodity price itself.

Considering gas prices have surged roughly 30% in that time, these moves might be seen as a disappointment, disproving the thesis that these stocks are highly-sensitive to the price of natural gas.

In reality, the analysis is a bit more complex. Many energy traders don't trust quick moves in energy prices, and they assume that profit-taking will soon ensue. If gas prices move back below $4 per thousand cubic feet (MCF), then these companies will generate a lesser benefit.

Futures contracts imply that gas prices will peak at $4.49 per MCF in February, 2014, and won't return to that level until 2018. The futures market appears to be simply ignoring the fairly sharp fall in natural gas inventory levels, and if inventories keep falling, futures traders will have to boost their price outlooks.

Another factor: these companies have hedged some of their 2014 output, and can only profit from the recent spike by locking into future hedges. Companies rarely share this data on a real-time basis. We won't hear more about their contract activity until fourth-quarter results roll in a month from now.

To be sure, these kinds of stocks, representing large and stable companies, are not the most highly-levered ways to invest in natural gas prices. For that, you need to look at the exchange-traded funds (ETFs) that focus on the sector. Working off of a list compiled by of the five most popular natural gas ETFs, here is a look at recent performance.

Clearly, in hindsight, it I had such high conviction that cold weather would soon arrive, natural gas inventories would plunge, and gas prices would spike, I should have suggested these trading vehicles.

But as I noted in mid-November, leveraged ETFs "it's proved to be downright foolhardy (in 2013) to buy leveraged ETFs that move at two or three times the rate of change (of the underlying commodity). I'm certainly not comfortable recommending any of them, as they represent more risk than most investors are willing to stomach. For that matter, a pullback in gas prices would hammer them hard. (Though the 3X Inverse Natural Gas ETN (NYSE: DGAZ), which has lost more than half its value in the past two months, would rally sharply.)

My take: Natural gas is likely to stay above $4 per MCF for the foreseeable future as the recent inventory trends are no mere blip on the radar. Any move toward the $5 per MCF mark would lead to concerns that producers will hike output, effectively capping any rally, but as long as we stay above $4, then the three stocks profiled earlier are likely to be subject to upward earnings revisions. And that could spell further gains.

Risks to Consider: The cold spell appears to have broken for now, so inventory levels may not drop as quickly as they have recently, which may lead gas prices to fall.

Action to Take --> The era of misery in the natural gas sector appears to have ended. Gas prices have been firming for nearly two years, and though you shouldn't anticipate much more upside from here, current prices are very supportive to industry profitability.

P.S. "America's Natural Gas Highway" is going to change the everyday lives of millions of American's, their children and their children's children. It's why energy tycoon T. Boone Pickens has invested millions in the highway and why Andy Obermueller, Chief Investment Strategist of Game-Changing Stocks thinks you should too. He's identified one "game-changing" company that's ready to take advantage of today's natural gas market... and it could lead to triple-digit gains. To learn more about this opportunity, click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.