How to Invest in Natural Gas2015-06-24
Natural gas is a gas that consists primarily of methane and is widely used as an energy source. The natural resource is important for the creation of fertilizers, and is now used to power a variety of applications including automobiles.
Supplies of natural gas are concentrated in a few regions of the world, and the fuel has historically been the source of political disputes in Eastern Europe, the Middle East and the U.S. The place of natural gas in the domestic energy equation has been widely discussed in recent years, with many advocating for increased adoption as an alternative to crude oil products.
Because natural gas is clean burning and found in massive quantities within U.S. borders, it has been hailed as a “fuel of the future” that will account for an increasingly larger energy market share in the coming decades. That factor has made natural gas a popular investment destination, as has the generally strong relationship between gas prices and the health of the U.S. economy. There are a number of options for investors to achieve exposure to natural gas, including futures contracts, stocks of companies engaged in the extraction and transport of the gas, and ETFs and ETNs.
Physical Properties of Natural Gas
Natural gas can be found in a variety of different locations. It’s often found in coal beds, oil fields and natural gas fields. Natural gas located in oil fields is often referred to as “associated”, while natural gas discovered in a dedicated natural gas field is described as “unassociated”. It is often a by-product of producing oil. Disposing of unwanted gas historically posed a problem to oil companies. Because natural gas had to be transferred to end users via pipeline, supplies in remote areas were essentially worthless and were often burned off–a process known as “flaring” that is now illegal in many countries. The development of energy infrastructure in recent decades has made it easier to transport and store natural gas produced from oil-related activities, and technological improvements have also facilitated the capture of this resource [see also Commodity Investing: Physical vs. Futures].
Natural gas maintains a low density, a physical property that makes it difficult to transport via truck or boat in its gaseous form. Because transocean pipelines are not practical from a cost perspective, natural gas has historically been a local commodity. Whereas oil produced in the Middle East can be shipped around the world, end users of natural gas are generally located in relatively close proximity to the fuel source.
Natural gas can be temporarily converted to liquid form (liquefied natural gas, or LNG) or compressed (compressed natural gas, or CNG), in order to make long-distance transportation through traditional sources such as ships more efficient both from a logistical and cost perspective. Technological developments have increased the use of LNG and CNG, and shipments of natural gas between continents has increased significantly in recent years as a result [see also Three Mining Companies With Robust Yields].
Natural gas goes through extensive processing before it can be used as fuel; almost all non-methane components must be removed before the commodity can be utilized as a source of energy. By-products of natural gas processing include carbon dioxide, hydrocarbons, and sulfur.
Uses of Natural Gas
Natural gas is a source of electricity generation that involves gas and steam turbines and is used widely by power plants. Compressed natural gas is used as an alternative to automobile fuels, and the number of natural gas vehicles has increased steadily in recent years. Natural gas is also used as a feedstock for the production of ammonia, making it useful in the process of manufacturing fertilizer [see also Invest Like Jim Rogers With These Three Agriculture Stocks].
Natural Gas Supply and Demand
There are four primary sources of natural gas:
- Gas-Rich Shale: This is the source for many natural gas reserves, but until recently had not been a focus of gas production.
- Conventional Gas Accumulations: Occurs when gas migrates from gas-rich shale into an overlying sandstone formation, and then becomes trapped.
- Tight Sand Gas Accumulations: Occurs when gas migrates from a source rock into a sandstone formation, but is limited in its ability to migrate upward.
- Coal Bed Methane: This type of gas is generated during the transformation of organic material to coal.
Russia is by far the largest global supplier of natural gas, followed by Iran, Qatar, and a number of other Middle Eastern countries. The world’s largest natural gas field is located off the shore of Qatar; the North Field is estimated to hold about 25 trillion cubic meters. That supply alone is enough to last 200 years at optimum extraction levels. However, because natural gas remains largely a local commodity, prices of natural gas in the U.S. will be impacted primarily by domestic supplies [see also Company Spotlight: Barrick Gold Corporation].
In the U.S., the largest natural gas deposits are found in Arkansas, Louisiana, Alaska, and Texas. Significant natural gas deposits are scattered throughout the western and southern parts of the country, though there are a handful of meaningful reserves located in Michigan, Kentucky, and West Virginia (see a map of the largest U.S. gas reserves).
|Country||Proved Natural Gas Reserves 2014 (in trillion cubic meters)|
|United Arab Emirates||6.1|
There have been several major discoveries of natural gas reserves in the U.S. in recent years, a trend that has put downward pressure on prices and increased momentum to emphasize gas as a primary source of energy. The Haynesville Shale, discovered in Louisiana in 2009, holds enough gas to match several years worth of consumption, and countless other discoveries have propelled the U.S. up the list of the world’s biggest owners of natural gas.
Natural gas is unique from many commodities in that it is generally used in close proximity to its source. As a result, natural gas supply and demand in the U.S. is generally insulated from developments elsewhere in the world. Whereas crude oil prices tend to spike when geopolitical tensions flare up in the Middle East, natural gas prices depend more heavily on the health of the U.S. economy and inventory levels. Natural gas prices and the prices of various products offering exposure to natural gas depend on a number of factors:
- Technological Developments: Natural gas is currently one of the cleanest sources of power available that utilizes hydrocarbons, a major reason for its widespread use. Some believe that fuel cell technology could ultimately become an even cleaner source of energy, but cost restrictions limit adoption at present. To the extent that fuel cell technologies become more cost efficient, demand for natural gas could decline.
- Weather Patterns: Demand for natural gas depends on weather patterns, as more fuel is used when households run air conditioners or heaters. As such, forecasts for moderate weather in the U.S. may send prices lower, while predictions of unseasonably warm or cold weather in big parts of the country can send natural gas prices higher.
- Storage Reports: Like any commodity, natural gas is impacted by inventory levels. The Energy Information Administration releases a report at 10:30 ET every Thursday detailing the current natural gas storage situation, and the price of the commodity often reacts to this data. If the drawdown is greater than analysts expect or if the addition to stockpiles is smaller, prices may jump. If the opposite is true, natural gas prices tend to slide.
- Regulatory Environment: Technological breakthroughs in recent years have given energy firms new tools for tapping into natural gas reserves, as a process known as hydraulic fracturing allows drillers to access natural gas stored in shale. But there have been concerns about the environmental impact of this process, and as more information is gathered it is possible that restrictions could be put in place limiting this practice. Eliminating this source of supply could have an impact on natural gas prices, so the regulatory environment should be monitored closely.
- New Discoveries: In addition to the massive discoveries in the U.S., Israel, Australia, and many other countries have uncovered new reserves in recent years. To the extent that new discoveries continue to be made, natural gas prices could have a relatively low ceiling.
- Futures Markets: Many investors achieve exposure to natural gas through futures contracts, meaning that the slope of the futures curve can have an impact on performance. When the market for natural gas futures is in contango–meaning that longer-dated contracts are more expensive than those approaching expiration–futures-based products will often lag behind a hypothetical spot return.
Investing in Natural Gas
Natural gas may have appeal as an investable asset for several reasons. First, because long distance transport is expensive and challenging, the fuel is impacted more heavily by supply and demand in the U.S. That insulates natural gas from external factors, such as geopolitical tensions elsewhere in the world. Natural gas can also exhibit significant volatility, especially following the release of inventory data. That may give natural gas appeal to short-term traders looking to profit from surprises in storage figures. Finally, some see natural gas as a component of a longer-term investment theme that includes decreasing dependence on foreign oil. Because natural gas is cheap, relatively clean, and found in abundance in the U.S., it is expected to gradually account for a larger portion of the domestic energy equation [see also Why Commodities Belong In Your Portfolio].
There are a number of opportunities for investing in natural gas, including futures contracts, stocks of companies whose operations revolve around the commodity, and exchange-traded products.
Physical Natural Gas
The low density of natural gas makes investing in the physical commodity nearly impossible–unless you have a network of pipelines and refining equipment handy.
Natural gas futures are traded on the Chicago Mercantile Exchange, with contracts priced in dollars and cents per million British thermal units (mmBtu) and each contract representing 10,000 million Btus. Listings for natural gas futures contracts are deeper than nearly any other commodity; contracts are available monthly for the current year plus the next 12 years. A new calendar year will be added following the termination of trading in the December contract of the current year.
The underlying for natural gas futures contracts is gas delivered at the Henry Hub in Louisiana.
Options on natural gas are also available. Listed contracts are available for consecutive months for the current year plus five additional years. There are 20 strike prices in increments of $0.05 per mmBtu above and below the at-the-money strike price in all months, and an additional 20 strike prices in increments of $0.05 per mmBtu above the at-the-money price will be offered in the first three nearby months. The next 10 strike prices are in increments of $0.25 per mmBtu above the highest and below the lowest existing strike prices in all months for a total of at least 81 strike prices in the first three nearby months and a total of at least 61 strike prices for four months and beyond.
Natural gas futures and options are subject to NYMEX position limits.
Investing in the stocks engaged in the drilling, extraction, refining, and transport of natural gas can also offer exposure to the price of this commodity. Like most companies, the profitability of natural gas firms depends on the prevailing market price for the products they sell. As such, natural gas companies tend to realize higher profits when natural resource prices are elevated—especially if significant portions of the cost structure are fixed in nature. It should be noted, however, that companies will also be impacted by other factors beyond natural gas prices, and certainly will not move in unison with spot prices in most instances.
Many large energy companies maintain significant natural gas operations in addition to oil drilling businesses. There are also some firms that focus exclusively on the fuel:
- Chesapeake Energy Corp. (CHK)
- Cimarex Energy Company (XEC)
- Devon Energy Corporation (DVN)
- Cabot Oil & Gas Corporation (COG)
- Range Resources Corporation (RRC)
- EOG Resources (EOG)
- SandRidge Energy, Inc. (SD)
- Suncor Energy, Inc. (SU)
- SM Energy Co (SM)
- Talisman Energy, Inc. (TLM)
[see the holdings of the First Trust ISE-Revere Natural Gas Index Fund for a more detailed list of natural gas companies]
There are multiple exchange-traded products offering exposure to natural gas, including both ETFs and ETNs.
- United States Natural Gas Fund (UNG): The most popular ETP option for natural gas exposure, UNG invests in front-month natural gas futures contracts. That increases correlation to spot prices, but also increases the impact of contango or backwardation, depending on the slope of the futures curve.
- iPath Dow Jones-UBS Natural Gas ETN (GAZ): This product also offers exposure to natural gas futures contracts that are approaching expiration. Unlike UNG, GAZ is structured as an exchange-traded note, and as such exposes investors to the credit risk of the issuer but cuts down on tracking error.
- United States 12 Month Natural Gas (UNL): This ETF invests in twelve different natural gas futures contracts, including the near-month contract and the next 11 contracts. That structure lessens the impact of contango while still delivering exposure to natural gas futures.
There is one other interesting ETF option for investors looking to gain exposure to natural gas prices: the First Trust ISE-Revere Natural Gas Index Fund (FCG). This product seeks to deliver returns that correspond to the ISE-Revere Natural Gas Index, an equal-weighted benchmark comprising exchange-listed companies that derive a substantial portion of their revenues from the exploration and production of natural gas. Companies must maintain a certain level of proven reserves to be eligible, and candidate stocks are ranked on criteria that include correlation to gas futures markets (see more on FCG).