I am a long term fan of Natural Gas and have posted pro-nat gas articles on this website in the past. It is weak now due to its "junk energy" status during an economic downturn. It is highly leveraged to the economy and does very well in a strong economy and very poorly in a weak economy. This is due to its primary use as an industrial energy supply and its seasonal use for building heating.

If (when) nat gas becomes a primary transportation fuel source alongside gasoline and diesel, its utility and value will soar. I think that time is coming soon. The easiest way to achieve a significant global reduction in green-house gas is by a conversion of transportation systems from gasoline to nat gas and electric power from coal to nat gas. This hasn't happened in the past for two reasons: (1) lack of distribution infrastructure (i.e. nat gas fuel stations on every corner); and (2) perception of uneven supply across the geography (nat gas is expensive to transport other than through a pipeline due to its low density as a gas). A third issue is the cost of the conversion of vehicles from gasoline to nat gas powered, but this is a manageable economic issue that can be addressed with tax policy, and is not a technology issue.

I see the Obama administration addressing the greenhouse gas problem through policies that favor nat gas. He will announce the framework of those policies today (Tuesday). Nat Gas is a good solution to provide energy independence and a cleaner environment. It provides a technology bridge to developing renewable energy sources like solar and hydrogen fuel cells. It will happen and should be the cornerstone of every portfolio.

The nat gas ETF, UNG, is flawed, but is the only pure play on nat gas pricing. The premium in the ETF due to a moratorium on adding futures to the ETF is down from 20% to 5%. That premium is manageable and makes UNG once again a decent way to play nat gas. North America energy producers are the other way to play nat gas: CHK, XTO, LINN, PWE, PVX, MRO, PGH are some of the stocks one can use to gain exposure to nat gas.

Flash Player 9 or higher is required to view the chart
Click here to download Flash Player now

Why is Natural Gas so cheap (3.87 per mmBTU as of today) while Oil is moving ever higher? This is a significant disconnect that does not make long term sense. Historically, the average ratio between West Texas crude and Henry Hub natural gas has been 8.5 to 1.  Currently, it is at a historic ratio of 19:1.

With oil at $72 per barrel, natural gas should be around $8.47. That represents a 125% potential pop in the price of natural gas if the price of oil stays constant. Many experts believe that oil is fairly priced right now, give the costs of exploration and extraction.

UNG is the easiest pure play on the price of natural gas. This ETF is based on natural gas futures and moves directly with that price. UNG trades for $14.50 as of today, but would be over $30 if natural gas normalized its pricing against oil. So, just on current relative value, natural gas is a value play with great upside potential in the intermediate term (12 months). But it is an even better play in the longer term (1-5 years).

President Obama and the Democrat controlled Congress will definitely pass some type of environmental legislation this year or early next. That legislation is aimed directly against carbon and its role in global warming (or the theory thereof, since it is not conclusively proven). In the next several months, either a "Cap and Trade" or a straight up carbon tax will be passed. The moderates in Congress and most of the heavy industrial world, faced with the reality of some type of legislation, are rallying behind a carbon tax for its simplicity and for the fact that the cost can be passed along to the consumer much more efficiently and without the distortion and potential fraud of cap and trade.

For natural gas, either scenario is very attractive. Natural gas per BTU of energy, is much cleaner than oil or coal, the two primary fossil fuel alternatives. So, if a carbon tax is passed by legislation this year, natural gas will immediately become more competitive. Its historical relationship to oil should decline even below 8.5. If it moves to 7.0, then the relative cost today should be $10 per mmBTU for natural gas.

Longer term, with or without a tax advantage over oil, natural gas promises to be used as a transitional fuel to alternative energies like solar, wind and geothermal. T Boone Pickens has proposed, and spent a considerable portion of his wealth, promoting the idea of natural gas powered vehicles. Once fuel cell powered vehicles become practical, within 10 years with government encouragement / subsidy, natural gas is likely to be the first fuel used by such vehicles. This reality will be encouraged if Pickens is successful in getting existing fuel stations in North America to add natural gas to their product offering at the pump.

Pure hydrogen vehicles are a better environmental option, since the byproduct of the chemical reaction is pure water. But the manufacture, storage and distribution of highly combustible hydrogen has many science, engineering and production problems yet to be solved.

So, how can we benefit from this megatrend?

The Canadian Canroys are one good way to anticipate this new trend.  Much of North American natural gas is in the western provinces of Canada. I have owned and benefited from Pennwest (PWE), Pengrowth (PGH), Provident (PVX), Daylight (DAYYF), Baytex and Harvest Energy for many years (until last July when the entire commodity complex hit the skids).  U.S. based producers include Anadarko, Chesapeake, XTO, Southwest Energy and Lynn Energy.   All the above offer decent dividends, though not nearly as attractive as a year ago, so there is somewhat less reason to buy and hold as there was in the past.

For extra leverage, sell "In the Money" UNG put options on the October $18 strike price (UNEVR) for around $4.50 premium per share of underlying stock (with the stock price at $14.50 as of today). This buys $1 of downside protection and provides over $3 of upside opportunity. If the price finishes above $18 on October 16, the puts will expire worthless and you will keep the $4.50 premium. The stock price of the UNG ETF will only need to move to about $5.00 from the current $4.00 for this to happen. But execute a "Buy to Close" order any where along the way, for example, when the premium falls to $2 for a double on your investment (times 5 for the inherent leverage of options) to lock in profits. This gives a 500% return in less than six months.

Because the market, especially commodity stocks, looks ready to correct, it may be prudent and profitable to wait on this until after a market correction.  I am looking for a move back down to SP500 of 875 in the next couple of weeks.  Once that move is done, it may be possible to sell the same puts for $5.50 (with the underlying UNG at $13). 

Have fun making money.