How to Profit on the NatGas Rebound

04/04/2011 10:17 am EST

Focus: ETFS

Richard Young

Editor, Young's Intelligence Report

An ETF basket of gas drillers is headed higher as prices catch up to oil and coal, writes Richard C. Young, editor of Intelligence Report.

First Trust ISE-Revere Natural Gas Index Fund (FCG) invests in companies with substantial natural-gas operations, including some of the best shale-gas companies in the United States.

Thanks to technological innovations like horizontal drilling and hydraulic fracturing, the companies owned by First Trust Natural Gas Index Fund have been ramping up production.

As you can see on my chart of US dry natural gas production, companies have mastered these new drilling techniques and are supplying the US with more natural gas than ever before.

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If that gas doesn't find a ready market here in the US, you can be sure it will find a home in the energy-hungry emerging markets of Asia.

China's central government has targeted a countrywide fuel mix that increases natural gas's share to 10% by 2020. And the US Energy Information Administration estimates that China's natural-gas consumption will increase 5% a year until 2035.

[The accident at the Fukushima nuclear power plant in Japan is likely to further increase demand for natural gas, as countries rethink plans for new reactors, argues George Wolff—Editor.]

Today, natural gas is trading at all-time lows on a BTU basis compared with its closest competitors, oil and coal. A BTU (British Thermal Unit) is a unit of energy measurement which can be used to directly compare the prices of different fuels.

On my chart of the relationship between WTI Crude and Henry Hub natural-gas spot prices below, you can see that for the price of each BTU of oil bought today, you could buy nearly four BTUs of natural gas. The only time the ratio has been as high was in the 1979 Iranian oil crisis.

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Lest you believe that the extreme ratio is only a product of recent Middle Eastern political turmoil spiking the price of oil, take a look at the chart showing the same BTU relationship between natural gas and coal.

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What's important here is the trend. You can buy 90% of a BTU of natural gas for every BTU of coal. But coal needs to be much cheaper than natural gas to be competitive. And the costs of transporting coal and removing its pollutants are much higher.

Natural gas should trade at a premium to coal, as you can see it did through most of the decade. Gas is easily transported via pipelines and burns cleaner than coal or oil.

The rules of arbitrage say these BTU ratios must come down. A BTU is a BTU.

Given room for premiums or discounts for transportation, storage costs, and pollution effects, one BTU shouldn't be worth any more or less than another in the long term. And given the demand for energy products in rapacious developing markets, the outlook for natural gas is good.

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