April 3, 2012
When a great investor points to a vastly underpriced asset, a natural first reaction is to devise the best strategy for buying it. Sometimes, however, the impediments to that strategy prove too great, something anyone will soon discover who listens to Jeremy Grantham’s assertion that “everyone who has a brain should be thinking of how to make money” long-term on natural gas.
Jeremy Grantham is bullish on natural resources, and in his most recent letter to investors he asserted that natural gas, in particular, is historically underpriced relative to oil. Exploiting this mispricing, he said, is one of the great opportunities for investors:
Natural gas is, for most purposes like home heating and electric utility plants, a better and cleaner fuel than oil or coal, but is for technical reasons in distress: there have been several recent decades in which the BTU equivalent price for natural gas did, at least for a second, reach parity with oil. But now it is at just 14% of BTU equivalency, the lowest in almost 50 years.
There is invariably a reason why an asset is underpriced. Indeed, if exploiting a mispricing was easy, it would rapidly be arbitraged away. But, as I discuss, making a well-considered long-term bet on the recovery of gas prices is not possible, without taking on substantial risk.
I will explore two vehicles that investors have available to invest in gas: ETFs that are designed to track natural gas prices and the equity of companies with large natural gas reserves. Unfortunately, neither is likely to produce the outsized returns that investors would hope, given the depressed price of natural gas.
First, however, let’s consider why natural gas prices are so low.
The current market for gas
Natural gas prices have plummeted in recent years, from a high of $13 or so per mmbtu (million BTU equivalent, equal to 1,000 cubic feet) in 2008 to around $2.30 today. Oil, of course, is not cheap right now, with prices around $110 per barrel. On an energy-equivalent basis, a barrel of oil would be about six times as expensive as 1000 cubic feet of gas. Today, however, the ratio of the price of a barrel of oil to a 1,000 cubic feet of gas is vastly higher than 6-to-1.
Because of very warm weather, the United States is ending the winter of 2011-2012 with near-record levels of natural gas in storage. Furthermore, domestic production is soaring, increasing 7.9% in 2011. This is the largest annual natural gas production increase ever, according to the Department of Energy (DOE). The DOE’s Energy Information Authority (EIA) is forecasting a slow recovery in gas prices on the basis of fundamentals, with an average price of $4 per mmbtu in 2013. Not surprisingly, producers are planning to reduce production of natural gas in favor of oil, since the timing of a recovery in prices is a major question.
T. Boone Pickens, himself a big investor in natural gas, claims that the short-term outlook for natural gas is not positive. To reconcile this with Grantham’s emphasis on the longer term, the challenge is to take a position that is relatively fault-tolerant in the near-term, while positioning for the long-term expectation that natural gas will recover.
Investing in natural gas ETFs
An investor cannot place a direct bet on the actual price of natural gas unless he is actually a participant in the physical market, with access to storage facilities, delivery mechanisms, and the like. This is a standard problem for speculators. Betting on a price increase in a commodity requires that you build in a factor to account for the cost of storage. The longer it takes until your bet pays off, the greater the drag of storage costs.
Investors who wish to include a commodity in their asset allocation mix typically employ a futures-based strategy. The most widely traded and liquid natural gas futures are the NYMEX Henry Hub Natural Gas contracts. The simplest approach is to purchase a portfolio of futures contracts and then to sell these contracts as they approach expiration, purchasing longer-date futures with the proceeds. This approach gives you exposure to the movement of prices without your ever taking delivery of the commodity.
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