By Dave Sterman
After a multi-year tumble, natural gas prices have sprung back to life, moving from below $2 per thousand cubic feet this past spring to around $3.80. Despite that move, the stars are aligned for more gains to come, perhaps towards the $5 mark.
Simply put, this industry is no longer producing enough output. In the summer of 2010, there were nearly 1,000 rigs pumping out gas in the U.S. That led to a painful glut-and a big retrenchment. Now, there are just 422 rigs in service, and at some drilling sites output is starting to wane as depletion takes root. Just to maintain a current level of output, more rigs will need to be put in service to offset the slowly declining production at existing rigs.
Yet as analysts at Morgan Stanley cautioned in a recent report, "supply should be slow to respond to improved economics (i.e. higher prices) owing to logistical challenges, more attractive oil economics, and higher breakeven costs outside the Marcellus (Shale)." That's why these analysts and others think natural gas prices will keep on rising in coming quarters. If they're right, then investors can profit from the ongoing gas spike with several ETFs.
Few stand to benefit from firming gas prices like the producers themselves. As prices rise, they can lock in long-term contracts that ensure them a steady and solid profit on their output. These hedging strategies allow them to keep those gains, even if gas prices reverse course.
The First Trust ISE-Revere Natural Gas Index Fund (FCG) owns many of North America's top gas producers, without too deep a concentration in any one particular holding. For example, its largest position is in Canada's Talisman Energy, which comprises 4.1% of the ETF, while its 10th-largest holding, Comstock Resources, accounts for 3.5% of the fund.
The First Trust ETF focuses on companies with at least 50% of their drilling program tied to gas production and is rebalanced quarterly to best reflect the stocks with the lowest P/E ratio, price-book ratio, highest return on equity, and greatest correlation to natural gas prices, according to Ryan Issakainen, First Trust's senior vice president and ETF strategist.
The fund's debut in 2007 was a case of bad timing as natural gas prices would tumble sharply a year later. Shares have subsequently made up for some of those losses, though at $17 the fund remains below the $30 seen in the spring of 2008. It's notable that natural gas prices have risen 80% in the past six months, while the FCG has risen around 10%.
That's because the portfolio holdings also have some exposure to crude oil, which has not moved up in price to the same extent as natural gas. And these producers still need to work off older contracts that were signed at lower prices before they can lock in new contracts closer to current gas prices. The 0.60% expense ratio is average for the category.
Investors who don't want exposure to contract hedge lag can go another route with exchange-traded products tied to spot and futures contracts. The U.S. Natural Gas fund (UNG), which invests in soon-to-expire gas price futures contracts, is a popular choice that trades 11 million shares a day. But it has a clear drawback because it can lose some value as it rolls over into the next futures contract if that next contract is higher-priced, a condition known as "contango."
Possible alternatives to this contango tangle are the United States 12 Month Natural Gas Fund (UNL) and the UBS E-TRACS Natural Gas Futures Contango ETN (GASZ).
The U.S. 12 month Natural Gas Fund tackles the contango problem by owning the next 12 monthly forward contracts, which provides exposure to near-term and mid-term gas price targets, as assessed by futures traders. The fund launched in November, 2009, and as result, its shares moved steadily lower throughout 2010 and 2011 as natural gas prices fell. However, in recent months, the fund has begun to rebound on the heels of firming natural gas prices.
Futures contracts don't respond very quickly to changes in the spot market, so the fund has gained just 12% over the past three months, even as natural gas prices have surged 60% in that period. Of course the converse is true: a sharp pullback in the spot market would have a much more muted impact in the futures markets, providing relative support for this ETF.
Still, a further spike in gas prices past the $4 mark would provide a commensurate lift for future prices. Right now, the November, 2013 contract is priced at $4.06, though a move past towards the $4.50 mark on the spot market could push the 12-month forward contract past $5, implying roughly 25% upside for this fund. However, the 0.94% expense ratio is a bit high due to a high level of trading activity, making it unsuitable as a short-term trading vehicle.
The UBS E-TRACS Natural Gas Futures Contango ETN approaches the contango issue from an unusual angle. This exchange-traded note is structured to capitalize on the spread between the near-term futures contract (which it shorts) and longer-term futures contracts. Yet it's important to understand that this fund isn't a play on rising gas prices. Instead, it benefits from a widening in the gap between the next month's contract and contracts for delivery many months into the future. That's what traders call "an upward slope." In fact, the fund has slumped roughly 5% since late August as the contract spreads have tightened and the slope has flattened.
Considering that the futures market works with a lag, the upward slope should eventually return (as the spot price falls or the futures prices catch up) and result in a rising price for this ETN.
These funds provide several angles to play a suddenly hot commodity. If you're bullish and expect natural gas prices to punch through the $4 mark, then the First Trust ISE-Revere Natural Gas Index Fund and The United States 12 Month Natural Gas Fund would work better. If you spot a pullback coming, then the UBS E-TRACS Natural Gas Futures Contango ETN could be more suitable.
Dave Sterman has worked as an investment analyst for nearly two decades. He was a senior analyst covering European banks at Smith Barney and was research director for Jesup & Lamont Securities. He also served as managing editor at TheStreet.com and research director at Individual Investor magazine.