The Smartest Way to Play Natural Gas

Natural gas is trading near historical lows and could explode upward in the next few months, especially as cooler temperatures begin to remind traders in New York that winter is on the way.

Investors can buy futures or exchange-traded funds to profit when prices rise, but there’s a better long-term play.

Natural Gas Prices
Natural gas prices plunged -70% in the second half of 2008 to levels not seen since 2002. The culprit was a drop in demand from factories and homes, which were using less energy because of the recession. But now, as the economy is starting to pick up, these prices won’t last long.

#-ad_banner-#One reason for that: Winter is around the corner, and that’s when natural gas prices tend to rise. Hundreds of thousands of homes and businesses use natural gas for heat, which will quickly burn off the nation’s almost-overflowing supply and push prices higher.

Also, many producers trimmed production for the simple reason that they don’t want to give their natural gas away. This completes the one-two punch — less supply, more demand — that is always a recipe for higher prices of any commodity.

Futures prices show investors expect gas prices to move higher. The current or “front-month” price for natural gas is $3.59, but the December price is +44% higher, at $5.15, and the December 2010 price is higher still, at $6.79 — +89% above today’s price.

The trend is clear: These depressed prices we are seeing won’t last forever. Natural gas is going up.
The only question is how to take advantage.

A popular play is buying natural gas through an exchange-traded fund called U.S. Natural Gas (NYSE: UNG), which tracks the price of natural gas using futures contracts. It can be useful to mirror short-term price swings, but it has its risks.

Funds that track commodities by buying future contracts have come under scrutiny by the Commodity Futures Trade Commission. At issue with commodity ETFs is their inability to track the price of the underlying commodity over the long term. As Nathan Slaughter, editor of The ETF Authority, pointed out, “[Ultra Oil & Gas Proshares (NYSE: DIG)] tumbled -70% last year as the price of oil collapsed. So you’d think a fund designed to move in the opposite direction would have soared. Wrong. UltraShort Oil & Gas ProShares (NYSE: DUG) actually declined about -10% as well.”

Investors who want to sidestep regulatory risk and tracking errors can buy natural gas producers. As gas prices rise, their profits typically follow. This strategy is more appropriate for investors with longer investment horizons.

The best-in-show winner among gas companies is clearly Chesapeake Energy (NYSE: CHK), the largest U.S. natural-gas producer. Chesapeake, despite the drop in natural gas prices, managed to increase revenue and profits in the second quarter from its year-ago results. This impressive feat was mostly attributable to its “hedging” program, which is meant to protect the company from price swings. In this case, it allowed the company to sell its natural gas above the market price.

Chesapeake, with 41,200 producing wells, has the third-largest proven natural-gas reserves in the country, which generates billions of cubic feet of production each day — production that will be worth hundreds of millions more as the price of gas rises.