Don't pass gas

Nat gas is by far the worst preforming major commodity since 2009. When it hit $2.30 about a month ago it was at its lowest point since 2002 and on an inflation adjusted basis, as low as it was in 1999. Anyone who tried to be a contrarian buying nat gas stocks and related ETFs has gotten their asses handed to them big time. But that was then, how about now? Could nat gas prices finally just about seen their worst? There's some good signs that it has.

I'm sure most of you probably know why nat gas is fundamentally appealing. One bbl (barrel) of oil has about 6 times the raw energy output of one mcf  (1000 cubic feet) of gas which means the price of oil is theoretically fairly valued when it's 6 times that of gas. Now, I realize it's not that simple because these 2 energy sources are not interchangeable - we can't conveniently switch everything that runs on oil derived products to nat gas and vice versa, but when you consider that right now oil is 40 times more than the price of gas there's no question this ratio is out of whack. Either oil is overvalued, gas is undervalued or some combination of both. I'd say it's the last one with an emphasis of  gas being undervalued. So, the potential is certainly there for the nat gas price to be a lot stronger in the years ahead.

We all know the culprit of weak nat gas prices - new advancements in drilling and fracing which allowed the ability to unlock gas trapped in shale wherby some massive discoveries of such have been made. The result has been  a huge new supply in gas. In addition, natural gas liquids (NGL) which are often found in these new gas plays have significantly lowered the break even (b.e) prices of many of these shale plays which adds even more to supply pressures. When you combine this with a very warm winter you have the perfect storm for a collapse in price and that's what happened. But now the fundamentals are lining up in favor of higher prices.

From what I've read, the average break-even cost for nat gas producers is $5-7/mcf. Apparently, a big reason why gas production has been so high in the past few years despite prices trading below break-even is because producers were able to hedge future production at favorable prices but those attractive hedging opportunities are no longer available. That's a major positive. Just recently, thanks to the collapse in the price these past 2 months, big producers such as Devon, EOG, Encana and Chesapeake threw in the towel and announced significant cutbacks in production. Meanwhile, natural gas rigs in service in the US has been falling precipitously from a recent peak of 997 in 2010 to 777 (as of last month)  and pretty much guaranteed to drop more after the cut back announcements by the majors. One article I read suggests that the market will be balanced when nat gas rigs in service are at 725 and that's quite likely going to happen very soon. So all in all, the supply glut is set to ease quite a bit in the coming months which should be supportive for higher prices.

On the demand side, we are starting to see a signficant shift by utlities from coal to nat gas but keep in mind not all utilities have the ability to make the switch. I'm not sure how much of an impact this switching will be....this is something I need to research more. If general economic activity continues to strengthen in the US, that too should add to demand pressures.  The warm winter was definitely a hit towards demand but that impact has probably largely played out already. So, things should be looking incrementally better on the demand side too.

The supply and demand issues I discussed above are medium term in nature. When talking about the long run, things look really interesting for nat gas. As a result of the recent shale discoveries, some reports suggest the US has a massive supply of nat gas that can make them energy self-sufficient for 100 years. Even if this is exaggerated there's little argument that the US has landed a massive windfall with all this shale gas. The two major ways they can exploit this windfall is to 1) become substantially more energy self sufficient promoting nat gas powered vehicles  and 2) wide scale exporting of nat gas to Europe and Asia where prices are north of $11/mcf. Whatever path is taken, demand pressures for gas will explode. However, it will require time and massive infrastructure investment before either option can be a reality and so in the meantime, it's best to focus on the medium term issues I discussed above.

From a sentiment and technical perspective there's some interesting things going on as well. The nat gas sector is clearly out of favor but despite this, I have seen countless failed attempts by retail traders in bottom picking UNG over the past few years. But I think we are finally at the point where even the most patient nat gas bulls and bottom pickers have given up. The capitulation by the majors to cut production also marks the kind of things you see near major bottoms.  Here's what Cramer wrote about a month ago right smack dab at the most recent bottom.

"Only in this totally nuts country can the low price of natural gas not be a positive. We have so much of this stuff and we have so many ways to use it that aren't being used that it is disgraceful.

We are headed to $1 natural gas in this country. The rest of the world is headed to $18. The differential is amazing. The rest of the world is clamoring for our natural gas, but our administration hasn't been able to figure out a single way to make it work for us. There's no encouragement to get trucks to switch from dirty imported diesel, and no mandates like those we had for ethanol, even as ethanol jacks up the price of precious food and uses a humongous amount of water. Ethanol is a scourge to this nation and natural gas is a blessing, but it doesn't matter.

Here's the real crime. I was perfectly fine with the Keystone pipeline being blocked if we simultaneously said, "We don't need dirty Canadian crude to run our cars we can use our own natural gas until the cost of electric cars come down and utilities switch to natural gas from coal over the next few years when the coal plants' lives expire."

Nope. Nothing. We just said, "Canada, go send your oil to Asia, will you? We don't want it. We want to import oil from Venezuela and the Middle East."

And that is exactly what we are doing."

Here is another thing that makes me believe that nat gas is at or close to a major bottom. At the most recent low at about $2.30 nat gas was trading 40% below the 200 DMA. That's quite extreme. To put that into perspective, the SPX was trading 40% below the 200 DMA at the November 2008 lows when it hit 750 and at the bear market bottom in March 2009. So, folks it's quite clear to me that we are at at least due for a major snap back rally in nat gas and quite possibly have reached or close to reaching a  final bear market bottom. 

What's happening with the natural gas sector right now reminds me a lot of what happened to gold in the late  90's. Before the bull market in gold began in 2001, it had been trading at or below the avg cost of production (estimated to be about $320-$350 at the time) for about 4 years, plagued by oversupply due to central bank selling. The selling was so pervasive that in September of 1999 "The Washington Agreement" was signed by major central banks to limit central bank selling which ended up marking the bottom of the gold bear market. This to me is similar to the recent announcement of major cut backs in nat gas production by the big boys. Getting back to gold... although the final bottom was made in 1999, it wasn't until 2001 when the bull market for gold began and by then all but the hard core gold bugs had given up on. There's no telling for sure when the final bottom will be made and just how that bottom will look like. It could be V shaped or gradual and drawn out like the bottom in gold was. If you compare nat gas to gold just prior to it's bull market,  I'd say we're somewhere in 1999-2001 so I'd say it's time to get some exposure but only if you can be patient and a strong holder. 

The best way to play the sector would be to focus on pure play stocks like ECA and CHK. I'd stay away from UNG or GAS.to because of the slippage due to contango in the futures. I have a position in High Arctic Energy Services (hwo.to) - a very undervalued small nat gas service company that operates in Alberta and Papua New Guinea. This company has gotten no respect whatsoever (probably because it's labeled as a nat gas stock) despite being very profitable. Their Canadian customers have focused on nat gas liquids plays which have been able to still thrive despite low nat prices (however at $2.50 that may not be the case anymore) and more importantly,  2/3 of their revenues come from a customer in Papua New Guinea (PNG) wherby they have LT contracts in place untill the end of next year and amgonst other things, is expected to have completed a LNG facility in 2 years to exports nat gas to Asia whereby prices have remained elevated and are well over $11/mcf.  The company is making tons of cash relative to it's market cap, has a solid balance sheet, trades at tangible book value  and has a p/e of 3! Even if there's a sharp decline in their Canadian operations due to the recent collapse in nat gas prices (which according to recent guidance doesn't appear to be forthcoming) the depressed stock price more than reflects this, plus they are still well positioned with their major customer in PNG which accounts for most of their earnings anyways. 

Given my heavy weighting in Canadian small cap energy service stocks last year, I followed the news flow quite closely with the sector I can tell you without any doubt that pretty much EVERY company in the sector  has focused their resources on servicing oil plays while shunning nat gas plays. This puts hwo.to in a potentially lucrative position long term. When nat gas becomes in favor again they will be one of the few companies readily available to meet the needs of the sector. In fact, the company has first call agreements with major customers. When the next boom in nat gas eventually takes hold, it will take a least a year before their competitors will be able or willing to shift back to nat gas service but by then the best opportunities will have been lost.  Hwo.to will be in a similar situation like Forest Gump was when his boat was the only one to have survived the storm and he had all the shrimp to catch  for himself! In addition to hwo.to I'm contemplating 2014 calls in ECA.to