Capitalizing on Cheap Natural Gas

While the price of a barrel of oil has doubled since early March, to about $68, natural gas prices are languishing at about $4 per million BTUs. In markets where traders make bets based on those standard measures of barrels and BTUs, the 18-to-1 price ratio for oil is about double the typical ratio of 8 or 9 to 1. That has some speculators betting natural gas prices will spike.

They're piling into the simplest form of a pure play on gas prices, the U.S. Natural Gas Exchange-Traded Fund. Assets in the fund, which invests mainly in gas futures contracts, have gone from less than $700 million in February to more than $4 billion in June. The bet hasn't paid off yet—the fund is down 38% in 2009, owing to weak natural gas prices as well as a quirk in the futures market that cuts into its return every month when it rolls over contracts.

Despite the historically extreme price ratio, those who watch the market closely say a rapid turnaround in price is far from a sure thing. Soaring production combined with declining demand from power plants, factories, and other industrial users has left storage facilities with near-record levels of natural gas in inventories. "It's just an ugly outlook near term because of the economy," says Jay Saunders, co-manager of the Jennison Natural Resources Fund. The amount of gas in storage as of June 12 was 23% higher than average for this time of year, according to the U.S. Energy Information Administration. And levels are just 2% below the all-time high ever stored.

Conditions could change rapidly if broad swaths of the U.S. have a heat wave, forcing more gas-fired power plants into action. A hurricane in the Gulf of Mexico that knocked gas production rigs offline would also do the trick. "Weather can have a huge impact on price," says Evan Smith, co-manager of the U.S. Global Investors Global Resources Fund (PSPFX). "You can't easily move natural gas in from outside the U.S. like you can with oil."

With prices likely to remain volatile for the next few months, fund managers say the smart play is in companies positioned to benefit from natural gas trends over the long haul. The Obama Administration's tighter environmental rules are likely to favor cleaner-burning natural gas plants over coal-fired facilities. Couple that with an eventual economic recovery, and long-term demand for gas should be healthy.

Shares of natural gas developer Southwestern Energy (SWN) are up 44% this year, but Smith says they could rise much more over the next few years, thanks to the company's extensive gas reserves that can be tapped at low cost. A riskier play is oil and gas producer Quicksilver Resources (KWK). Last year investors feared its debt load would cause problems, but fresh capital from venture partners should ease concerns, Smith says.

Big gains in natural gas stocks this year make Edward Maran, co-manager of the Thornburg Value Fund, nervous. He favors more diversified plays, such as Marathon Oil (MRO) and Apache (APA), which would benefit from higher natural gas prices. Plus, they are a better value, he says.

Jennison's Saunders agrees that it's not the time to buy natural gas producers. He expects the stocks to fall in the second half and not recover until 2010. After a price drop, his top picks include XTO Energy (XTO) and Range Resources (RRC).

Even if prices rise, gains on the Natural Gas ETF will likely lag. It owns a huge slug of futures contracts on gas that expire every month and must be rolled over into the next month's contract. Since gas prices are higher on contracts for future months than the current rate, it loses money each month when it rolls contracts forward.

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