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.

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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.

A response to a post by my good blog friend, Nirav:

Nirav, this is the problem with professors having opinions. Some people may want to think those opinions are more meaningful or well-informed because a given professor happens to be employed by a school like Stanford, or NYU (Roubini). But, such professors opinions about the future are no better than yours or mine. Professors should teach, and not opine.

The first thing wrong with Taylor’s opinion is his lack of command of basic financial math. A 100% change in nominal GDP over 10 years (and the resultant 50% cut in debt to GNP ratio) does not require a 10% annual inflation, but a 7.2% inflation, according to the Rule of 72, something any college finance or economics professor should know. I fully expect a 6-7% inflation within 2 years and think the Fed and Treasury are actually trying to orchestrate that.

The second thing wrong with the Professor’s opinion is the statement that a “permanent 60% tax increase would be required” to balance the budget. That statement is inconsistent with the 10% inflation conclusion. I think taxes could be left unchanged, or only increased to the degree Obama proposes, along with spending decreases, and inflation will do the rest. Not only will inflation cheapen the debt over time, it also will increase the number of dollars in which the debt is paid off. Anyone who owned a home in the 1970s remembers what a good deal inflation was at that time, so long as the mortgage was fixed. You could buy a $40K home, watch it appreciate to $80K with inflation, but pay off the debt as though it were still $40K. To the degree the Feds fix our interest costs (by issuing 30 year bonds which they should be doing in a big way right now), we will all benefit from the repayment in debt with ever cheaper dollars.

Inflation is the only way out of this box. I think the 1970s scenario is not only likely to occur, but welcome. It helped us resolve our Johnson era “guns and butter” Great Society debt of the 1960s, which in its time, was every bit as problematic as where we are today.

I would go on to say that as a responsible investor, it is important to try and anticipate the future, and not wait for it to run you over.  If inflation is in our future, as I think it most surely is, then a prudent investment strategy will take that into account.  The way to not only beat, but prosper from inflation is to own hard (real) assets, or stocks thereof. 

Oil, natural gas, industrial metals, precious metals, timberland, ag commodities, all the equipment suppliers to those industries (Joy Global, Deere, Cat, Monsanto, Nabors, Transocean, Dow Chemical, Dupont), and even real estate or REITs in the near future (once RE stops deflating) will all benefit from a long period of moderate inflation.  The Fed has demonstrated in the past its ability to prevent hyper-inflation, so that should not be a great worry.  Ben Bernanke knows the economics playbook very well.  So, rather than nashing teeth over the course of easy money and tax deficits, instead, put those actions to your own advantage.

Here is his post:

How to Reduce a Trillion Dollar Deficit

Q: Did Cramer signal the end of the Gold run by shrieking its praises in his show last night? He gushed about the coming $1600 Gold price (along with $16 wheat, and $16 Nat gas, which may suggest the gold target was more about numerical alliteration than calculation).

A: Well, the commodity boom can't continue if the recession talk gets worse. Commodity demand has to decline with a globally weaker economy. All the price increase can't be explained by dollar weakness. So, I am expecting a big selloff in the commodity stocks as they have been driven up by speculation and a thin market (not so much equity chased by a lot of dollars). Gold and oil will be part of that selloff, along with the ag commodities. For this reason, I am light on all the commodities, which are the current bubble. (The fact that Cramer is pounding the table for commodities seals that prognosis for me).

But after a big blowoff, they will be strong again and continue to rise as economies recover around the world, probably late next year. The dollar should strengthen later this year when other govmts cut their own interest rates to reflect the global recession that has begun. A strengthening dollar will also help lower commodity prices in dollar terms for the next 12-18 months. By the end of 2009, there should be another gold and oil buying opportunity with gold at $700 and oil at $70. That is my take, anyway.

In the meantime, the Canroys should be fine on a cash flow basis, as they are only factoring $60 oil into their cash flow and dividend forecasts. They will probably sell down on price, though, if this all comes to pass.

TO: Patrick Dorsey, Morningstar Editor:

Patrick, I found your analysis of the oil sector in “Fool’s Gold in the Oil Patch” posted on the Morningstar.com website to be highly flawed in its assumptions. Although you try to support your arguments with data from Morningstar, the data does not at all confirm the points you are making. I found your chart on the price of gasoline versus demand in California to be particularly unimpressive. It makes the assumption that gas prices in the US respond to demand in California. I don’t think so. Gas prices respond to the cost of oil first, and the availability of refining capacity second. A maintenance shut-down at a large refinery has much more to do with short term price variations in gasoline than does demand. Demand for gasoline changes in the short term due to seasonal factors, not due to driving patterns.

To dissect your weak arguments, first examine your statement about the acceptable price of a barrel of oil to the makers of the market, namely OPEC and the Saudia Arabia princes. It is flawed from the outset. You make the point that they are implicitly targeting a mid-30s price for oil, yet on CNBC this morning, Prince Alaweed stated that Saudia Arabia has abandoned that target and are instead targeting $40-50 / barrel. He stated OPEC’s comfort with $50 per barrel oil based on the observation it was not causing significant global economic damage. So your argument about where the price of oil will settle is already in danger.

Next, you make the case for the long run price of oil per barrel to be around $20. This is incorrect. Please cite your sources when you make statements such as this. The long run price is closer to $40 per barrel. Someone “Infinitely” (your choice of words to describe where oil would have to go to make a good investment) more credentialed than you to make statements about the long price of oil is Ben Bernanke, one of the Federal Reserve Board members and the leading candidate to replace Allen Greenspan as chairman. In a speech / article he authored in October 2004 (http://www.federalreserve.gov/boarddocs/speeches/2004/20041021/default.htm) he makes the compelling case, backed up by serious research, that $39 is a minimum price based on industry data. He references that as of October last year, the futures market was implicitly pricing the long run value of oil between $38 and $60 per barrel (2/3 probability). Of course, the futures market has priced oil even higher recently (as of April 2005), but we will let that point go for now.

Your financial analysis of the market, using Morningstar “return on invested capital” data appears compelling and may “Fool” some of your readers. However, it does not take into account the backward looking nature of the data. 2004 industry returns were based on oil prices from 2003 and 2002, since most industry players hedge in the futures market to smooth their earnings. The industry profits do not respond instantly to changes in the sales price of oil. 2005 and 2006 oil prices will be much more informative about the effect on industry profits of price per barrel in 2004.

Also, your position is in opposition to (besides the Saudis), T. Boone Pickens and Tom Petrie (of Petrie-Parkman) all of whom know much more about the industry than do you. Check out their websites and do a little research.

What your thesis completely ignores is the significant changes in global demand and supply over the past 10 years. In the 80s and 90s, the Pacific Rim nations developed as suppliers of electronic and heavy industry goods to the USA. Their development did not require significant increases in oil-based energy. It did not drive demand higher at a time when global oil reserves were still sufficient for global demand. Now, however, nations with much larger land mass per capita are undergoing development (China, India, Brazil, and Eastern Europe and Russia to a lesser extent). These nations will be voracious consumers of oil-based energy to meet their public’s transportation needs. Alternatives to oil-based transportation are well off in the future. Fuel cell technology is more than a decade from commercial reality (check out the price of Ballard Energy stock). Even when it becomes a reality, the first versions of fuel cell vehicles are expected to run on natural gas. So your demand story based on replacement technologies is just plain wrong.

The supply story is equally wrong. In the past, there was always plenty of cheap oil to exploit when demand increased, allowing for supply to meet (or exceed) demand. This was the case in the 1970s when the Middle East oil infrastructure was not completely developed. Now, however, the easy oil is gone. There are no new discoveries where, like Jed Clampett, you can shoot your shotgun at the ground and have oil spurt out. All the world’s oil, even in Saudi Arabia, will require more expensive techniques for extraction, at the very least pumping and in many cases stimulation techniques involving insertion of chemicals and /or steam into the wells. This will raise the bar on the minimum economic cost of a barrel of oil. Producers do not produce for long below their break-even point which puts a floor under the price of oil. That floor is going from $20, where it was in the 80s, to $40, where it will be by 2010. This is the information you can glean from industry experts if you will take the time to research the industry, before spouting your wisdom.

The bottom line: I am glad there are people like you to scare investors out of the oil market. It leaves better investing opportunities for people like me.