The Case for a Natural Gas Rally

Bearish Market

So far this year, natural gas has experienced none of the strength that Crude has. This can be attributed to several things. Not the least of which is a lack of speculative activity from the financials. Indeed, the global deleveraging has caused trading firms to pull in the reins on all but the most liquid assets traded.

We discussed this with some industry participants. Commercial and financial people were asked: Heating oil companies, business owners, brokers and a Washington PR firm. We were surprised to find a decent size minority bullish in the intermediate term. Here is what we came away with.

And Our Survey Said….

Right now Natural Gas has a couple things working against it. Gas is pricing demand destruction on the back of this deflationary recession. It also has a fresh source of low cost supply from Shale in places like the Marcellus deposit. And there is a lot more shale out there.

To put in a decent bottom, the market needs a reduction in CAPEX by producing firms. This has already started at the margin, but more has to happen.

One decent indicator is west coast production. Many small and mid size producers cannot turn a profit with Gas in the $2.00 area. That would put Henry Hub between 2.75 and 3.15. That is the opinion of one 25+ year industry veteran at a New York hedge fund.

One voodoo witch doctor (AKA a technical analyst) thinks that Natural Gas will put in an L shaped bottom with a rally when Crude gets back in the $60 dollar range. By the way, he is bullish oil as well and he has good tea leaves.
Natural Gas is also a widow maker. Natural Gas likes to take out a major bullish player before it rallies. Bullish players like Amaranth, Mother Rock, BMO, and several recent fund blow ups fit that bill. Did FC Stone’s recent situation qualify? We will see.

Obama Isn’t a Coal Fan

Another bullish factor is the political atmosphere in DC towards coal. President Obama administration’s aggressive anti- coal stance is well known. This can only help Natural Gas as more power generation changes over from coal.

Late last year, Obama said the following: “So if somebody wants to build a coal-powered plant, they can. It’s just that it will bankrupt them because they’re going to be charged a huge sum for all that greenhouse gas that’s being emitted.”

Once this banking crisis is over, the administration will probably resume its aggressive stance to putting coal power plants out of business. Nat gas will get major breaks and be incentivized to produce power. Cap and Trade credits are the beginning.

Choices

So, if you are bullish how can you play it? ETFs are the current rage for commodity investment. The risk here, as in the USO oil ETF, is the carry. “Do not buy futures or a physical ETF”, says an ETF trader. The back part of the curve is too steep and the seasonality will kill you. “If you think USO carry is bad, you ain’t seen nothing until you’ve seen Natural Gas seasonality.”

Another’s advice was to look for pure play producers or an Industry ETF in the equity sector. MLPs are a good start. They must return up to 90% of their profits to shareholders. But beware, MLPs’ are very sensitive to Tax policy changes. The key is what piece of production you get. MLP choices cover pipelines, exploration, different locales, and combinations of the above. The other factor is management’s philosophy on hedging. If they hedged and how they hedged should be considered.

Some legendary investors feel the same way about MLPs. Last we checked, Leon Cooperman’s Omega fund owns several pipeline MLPs. Seth Klarman owns a few as well. And of course, T. Boone Pickens has bought T.V. time extolling Natural Gas’ virtues. This sector has gotten beat up along with the broader market. We guess dividend security is something to consider. “Long puts anyone?”