Investors: Don’t Trade Natural Gas Until You See These Charts

By Chris Marasco - October 14, 2012 | Tickers: BP, LNG, CHK, XOM, UNG | 0 Comments

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Recently an investor was complaining about the performance of United States Natural Gas (NYSEMKT: UNG).  We both agreed that UNG has been a bad play on natural gas, specifically because of the high costs weaved throughout the ETF.

The fund’s .96% expense ratio is not too high.  However, strong contango has hurt the ETF’s performance.  Contango occurs when the futures market is priced higher, farther out into the future.  Thus, when the fund managers roll its positions into forward months, the fund enters at a price just above the spot price, depending on the timing of the purchase.

As a result of this, I began looking for other ways to trade natural gas.  Here is what I found.

3 Ways to Trade

There are three main ways to trade natural gas:

1. Trade the futures – the downside with the futures is that investors must roll them manually, they are extremely volatile, and they often require high margin.  Natural gas futures are not suitable for most investors.
2. Buy a tracking ETF – UNG is one example, but the investment has high fees and faces losses over time from contango.
3. Trade stocks highly correlated to natural gas – this move allows investors to participate in natural gas price movement, and it also gives the opportunity to earn dividend payouts.  The downside is that few companies are involved solely in natural gas.

Personally, I feel that all three of these options can come into play at different points in portfolio management, but my preference for long-term holdings is to trade stocks highly correlated to natural gas.

Here is the correlation analysis of four natural gas-producing stocks.

Correlation Analysis

Correlation tracks how one security trades based on another security.  If a correlation is 1.0, then the two securities trade in lockstep.  If -1.0, then they move in opposite directions.  A correlation of 0 infers that the two securities move independently of each other.

For this analysis, I have compared the stocks to /NG, the natural gas futures, and have used a correlation of 50 periods, meaning that the correlation number represents the price movement over the past 50 trading periods for both securities.  Note that when markets fall in lockstep, the correlation numbers are skewed.

Cheniere (NYSEMKT: LNG)

Cheniere operates natural gas “terminals,” essentially transportation piping for natural gas.  Cheniere is building an export facility in Louisiana, and it is the only company that received approval to export natural gas to countries that do not have a free trade agreement with the U.S.  Finally, Cheniere is a niche company that often profits when it transports natural gas – and more natural gas can be used in production, and therefore transported, when prices are lower.

Exxon Mobil (NYSE: XOM)

Exxon is the top producer of natural gas in the U.S.  If the U.S. rules that Exxon can export natural gas, shipped in the form of liquid natural gas (LNG), to countries without a free trade agreement, Exxon will receive higher prices for the commodity than in the U.S.

Also, Exxon is expected to invest $236.5 billion between 2012 and 2016, a massive amount that could reduce the firm’s creditworthiness.

Chesapeake Energy (NYSE: CHK)

Chesapeake ranks right behind Exxon as the second-largest producer of natural gas in the U.S.  However, Chesapeake has been focusing less on its natural gas investments, and more on its investments in oil, where it is a top-15 producer.  Despite reigning in drilling expenses by 27% next year, Chesapeake still faces a $3 billion shortfall between cash flow and projected investments, making Chesapeake a more risky play than competitors.

BP (NYSE: BP)

BP is still recovering from the 2010 Deepwater Horizon spill, the worst offshore spill in U.S. history.  As a result, the company has been selling assets, both onshore and offshore, to cover anticipated fines and penalties.  However, BP still remains a strong producer of both oil and natural gas, and it has teamed with Exxon and ConocoPhillips to build a plant in Alaska that would export LNG to other nations.

In all, natural gas has proven to be a tough commodity to trade.  The futures contain a great deal of leverage for the unwieldy commodity, and the tracking ETF has brought on major losses. 

Thus, I believe that directly trading correlated securities provides a nice way to play natural gas, so long as the markets do not begin a free fall. 

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