The Worst Investments of 2010: Natural Gas

12/27/2010 10:08 am EST

Focus: GLOBAL

Igor Greenwald

Chief Investment Strategist, MLP Profits

The fuel everybody wants to succeed was finally supposed to. It didn’t, and here’s why.

Sometimes, the best investments are the ones we don’t make. If you’ve dodged the Fateful Five of the past year’s most disappointing market themes, here’s to your foresight and/or inertia. It’s a distinction some people with exceptionally deep pockets can’t claim.

Far be it for us to entertain ourselves with other people’s mistakes.

In fact, some of the biggest losers of 2010 will turn into winners one day. But not overnight, and certainly not because the calendar has turned over.

This Was the Script
By now, gas producers drilling plentiful gas from newly accessible shale deposits should have cut output in response to disappointing market prices. Many of the new shale wells were expected to be quickly emptied. At the same time, the economic recovery should have boosted slack industrial demand.

The combination of diminishing production and increasing demand was supposed to lift the prices once and for all from the recessionary lows, allowing natural gas to catch up to the rally in most other commodities.

In February, the US Energy Information Administration predicted that natural gas would average $5.37 per million Btu during the year, up 36% from 2009. Two months earlier, Merrill Lynch analysts had suggested the price might reach $7.60 per MMBtu by the end of 2010.

This Is What Happened
The natural gas producers, many of them well-hedged at prices far above the spot market, pumped up the production volume throughout the year. By April, the number of rigs deployed to drill for gas in the continental U.S. was up 46% from nine months earlier. The shale wells exploited with the aid of water pressure and horizontal drilling proved more plentiful and durable than anticipated. Instead of falling as forecast, output rose 3.5% this year. Natural gas prices have averaged $4.37/MMBtu in 2010, a full dollar below the EIA’s February projection.

Who Got Hurt     
A year ago, Exxon Mobil (XOM) bought out gas producer XTO Energy in an all-stock deal valued at $41 billion and a 25% premium to XTO’s market price. Exxon shares, which fetched almost $73 before the deal was announced, slid below $57 by July 1 and are only now creeping back up toward $73, despite considerable increases in the price of oil and gasoline. In the four months following the XTO acquisition, the price of natural gas dropped 12%. Exxon likely paid billions more than it had to, and the toll on its own share price is an order of magnitude up from that.

Natural gas prices are down 8% year-to-date, crimping the bottom lines of producers. But that’s a tickle next to the 42% decline this year in the shares of the United States Natural Gas ETF (NYSE: UNG), which has chronically underperformed the commodity it purports to track. UNG coughs up value every time it has to trade in expiring natural gas futures for the next month’s more expensive contract, a mug’s game it plays like clockwork. Investors would have been much better off in the First Trust ISE-Revere Natural Gas Index (NYSE: FCG), an ETF made up of gas producers that’s up 8% in 2010.

How Far Is Down
For UNG, with its regularly scheduled losses rolling futures and a history of lousy performance, no lowball guess is out of order. For natural gas itself the floor is clearer, since at some point most of the hedges run off and production below a certain price point becomes uneconomical.

How Soon Is Up 
The trouble is, that point may well lie beyond 2011, when producers will still need to pump out gas to avoid losing some of their most promising leases. According to Raymond James, 34% of next year’s gas production is hedged at an average of 44% above the current spot price. Some producers are getting funds from foreign partners who want them to keep pumping. Raymond James expects investment in new output to outstrip cash flow from operations, and to keep prices “at depressed levels.” The EIA concurs.

With gas storage near record levels and spare storage capacity likely to be exhausted in 2011, prices may well need to head much lower before companies meaningfully curb production. This hasn’t scared off bargain hunters like Carl Icahn, whose increased 5.8% stake in Chesapeake Energy (NYSE: CHK) had that shale play rocketing 9% Monday. But perhaps Icahn is hedged with springtime put options on UNG, which seem an even bigger bargain.

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