How Investors Can Bet on Rising Natural-Gas Prices

While crude-oil prices have been rising since March, natural-gas prices have held steady. The well-known mathematical relationship between these two energy sources suggests that prices for one of them -- most likely natural gas -- are out of whack. If so, shares of companies that explore for and produce natural gas could be worth snapping up.

Here's how the math works: A barrel of oil produces 5.8 million British thermal units of energy. So, in theory, a barrel of oil should cost roughly six times as much as natural gas, which is priced in million-Btu increments. In reality, the price gap is usually wider because oil can be easily shipped all over the world, while natural gas is harder to transport. In futures trading, a barrel of oil, on average, fetches about nine times as much as a million Btu's of gas.

Lately, though, the gap has been much wider. In June 24 trading on the New York Mercantile Exchange, futures contracts for July delivery of oil closed at $68.67, about 18 times the $3.76 price of a natural-gas futures contract. Earlier in July, the ratio was 18, its widest margin since 1991. This seems to suggest that eventually some combination of rising gas prices and falling oil prices will bring the ratio closer to a normal level. "Watching that Btu-equivalence ratio makes a lot of sense right now, especially because it is at such an extreme," says Kent Croft, manager of the Croft Value fund, which owns several firms that produce natural gas.

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The likeliest scenario is that natural-gas prices will rise, given that oil prices have already surged more than 60% since March. Gas prices, meanwhile, have been flat since then, and are down by two-thirds since the summer of 2008.

But there's no telling when this convergence might occur, and there are signs that, in the short run, we won't see the price of natural gas rise much, if at all. That's largely because there is a glut of gas. In mid June, inventories of gas in underground storage were 32% higher than a year ago and 23% higher than their five-year average, according to the Energy Department. The excess supply can be blamed on unusually cool spring weather -- about one-third of gas supplies are used to generate electricity that powers air conditioners, among other things. The recession, which has curtailed manufacturing, is also contributing to the glut. Industrial companies consume another third of gas supplies.

Another factor depressing prices: A report in June indicated that the U.S. has about 100 years' supply of natural gas at current production levels. That is about 35% greater than the previous estimate.

Still, patient investors should view these near-term developments as seeds of an eventual resurgence of natural gas. In gas, as in other commodities, a glut usually leads to steep cuts in production, which eventually cause supply squeezes and higher prices.

Some firms that have decided the current price of gas makes it uneconomical to drill for more have already cut production. EnCana (symbol ECA), Canada's largest oil-and-gas producer, said in June that it had shut down wells producing a couple of hundred million cubic feet of gas a day.

Earlier, Chesapeake Energy (CHK), a U.S. producer, said it was cutting production by 400 million cubic feet a day. Energy-services firm Baker Hughes, which tracks the number of drilling rigs in use, says the count of working natural-gas rigs was 685 in mid June, down 57% from the 1,606 rigs at work during the summer of '08.

Although it will take time to work through current inventories of natural gas, the timetable could be unexpectedly accelerated by an active hurricane season (which can interrupt drilling in the Gulf of Mexico) or by an unusually cold winter, which would increase the use of natural gas for home heating. A global economic recovery would also spur demand.

Keep in mind that gas prices normally fall in the summer and rise as winter approaches. Futures contracts for delivery of natural gas in December are currently priced at $5.67, significantly above the price of near-term contracts.

Over the long term, several factors point toward rising demand for natural gas, including its increasing use in China to power cars and buses. In addition, because gas is a clean-burning fuel, it will be used more and more in place of coal in power plants. A cap-and-trade system to limit carbon emissions, which could be imposed by governments to effectively ration the use of dirtier fuels, would accelerate this trend.

Investors can bet on rising natural-gas prices either through exchange-traded funds that invest in gas futures or though shares of companies that produce natural gas. Prices of ETFs that buy futures, such as United States Natural Gas (UNG), can be volatile and for technical reasons can lag the price of natural gas at times. Besides, if gas prices surge, the earnings of gas producers -- and thus, their share prices -- can rise at a faster rate than the prices of the commodity itself.

One of the firms that will benefit most from rising gas prices is Devon Energy (DVN). Natural gas accounts for about 65% of the Oklahoma City firm's production. It delivers 2.5 billion cubic feet of natural gas per day, about 3% of the gas consumed in North America. At their June 25 close of $55.81, the shares are down by more than half in the past year.

Houston-based Apache (APA) produces about 1.6 billion cubic feet of gas daily, accounting for about half its total output. The firm expects to increase production by a healthy 6% to 14% this year, and has plenty of cash for acquisitions. At $71.44, its stock is down by half over the past year.

Fund manager Croft likes another Houston-based firm, Southwestern Energy (SWN), because it produces gas at a relatively low cost and can profit even when gas prices are low. As a result, Southwestern's shares, which closed at $38.69, have held up relatively well over the past year. The firm is a major producer in the Fayetteville Shale area in Arkansas, a prolific gas-producing region.

Energy-related ETFs are heavily weighted toward oil. But a regular mutual fund worth checking out is Fidelity Select Natural Gas (FSNGX), which at last word owned stocks of 78 gas producers, including Devon and Southwestern. Expenses are 0.85% annually. The fund surrendered 55% over the past year through June 25, mirroring the performance of the commodity. But if gas prices pop, the fund should enjoy a strong upward move, too.