Natural Gas ETFs: A Futures Speculation, or an Investment in the Future?

Mounting concerns about energy independence, emissions reductions, and affordable power have heightened the demand for energy alternatives. While not all available options are economically viable, recent times have seen natural gas touted as the "fuel of the future" in the United States. The environmentally conscious look to natural gas as a "bridge fuel," predicting that it will replace its carbon-intense cousins, coal and oil, until technological advances allow carbon-neutral energy sources to supersede fossil fuels altogether.

While it has generally taken a back seat to petroleum in the energy mix, stratospheric oil prices leading into July 2008 sparked widespread interest in natural gas. Crude prices are well off their $145 high, but the buzz surrounding natural gas has been sustained by fears of aggressive emissions regulation and the recent discovery and proliferation of vast domestic shale reserves, which notably increased last year's production.

The natural gas market has faced a prolonged downturn due to multifaceted economic drivers, but the long-term outlook for the energy source remains unchanged. There are several ETFs that may be used to establish or expand exposure to natural gas, but prospective investors should understand the context of the recent buzz, and that begins with an understanding of the energy space and the highly cyclical nature of natural gas.

The Role of Natural Gas in the U.S.
The United States Energy Information Administration segments total energy supply and demand by source and sector. The energy mixture in the United States is made up of petroleum, natural gas, coal, renewable sources (such as wind and solar), and nuclear, representing 35.3%, 23.4%, 19.7%, 7.7% and 8.3% of the total supply, respectively, as of this writing. While nearly all of these sources focus primarily on powering a single demand sector, natural gas differentiates itself as a truly multidimensional fuel. It supplies the industrial, residential and commercial, and electric power sectors in comparable allotments of 32%, 35% and 30%, respectively.

The only U.S. sector in which natural gas lacks a foothold is transportation, as roughly 94% of transportation's energy demand is satisfied by petroleum. Technical feasibility is not, however, natural gas' constraint in this case. Despite lower power output than gasoline vehicles, compressed natural gas vehicles are widely used in a number of regions outside North America, most notably Southwest Asia and South America.

Kelly Blue Book notes that refueling compressed natural gas vehicles is roughly 30% cheaper than traditional automobiles. The lack of U.S. market penetration can be primarily attributed to standardization of the auto industry and its infrastructure for gasoline use. The bottom line is this: Natural gas is capable of satisfying energy demand across all sectors of our economy in terms of its performance, and if a near-term bridge fuel is in fact required to stand as an alternative, natural gas is a prime candidate.

Though natural gas may be an economically and environmentally viable alternative to oil and coal, there are several other competing alternatives. Solar and wind generation are carbon-neutral options that require virtually no variable cost inputs. Federal supports have bolstered the near-term economic viability of both sources. With a $247 million budget, 2010 has seen a nearly 41% increase in federal funding for solar power over 2009. Likewise, the federal wind-power budget increased 45% to $79 million over the same period.

There are several problems intrinsically tied to both energy sources. The wind does not always blow, and the sun only shines for half the day at best, making them both intermittent sources of power. Current technology does not allow energy generated by wind and solar to be reliably stored in large quantities for use around the clock.

Grid stability remains the foremost concern, so utilities will continue to need backup natural gas generating capacity. Further, federal supports do expire, and are politically driven, so extensions are not guaranteed. Economic and technological limitations dictate that neither wind nor solar will be capable of replacing oil or coal in the near term, though they are likely to remain ancillary sources of generation as technological advances are made for both. This prompts the need for a bridge fuel in a possibly carbon-constrained energy environment.

While nuclear is charged with being environmentally disruptive to local marine life and running the risks of catastrophic meltdown, it is the only practical low-emission option outside of natural gas. Building even an average-size nuclear plant costs several billion dollars and is no small undertaking for even the largest utility companies. Banks and debt markets recognize the magnitude of this project-specific risk and have been reluctant to provide financing even before the onset of the recent financial crisis. In a departure from the status quo, however, the U.S. Department of Energy has pledged nuclear-construction loan guarantees for the first time in decades.

Last February,  Southern Company (SO) received $8.3 billion in federal loan guarantees to build the first two new reactors in the United States in more than 30 years. The DOE followed up with a $2 billion pledge to Areva CEI (Euronext Paris) for a front-end enrichment facility in Idaho. Such pledges signal increasing government support that may expand to other companies and indicate federal acknowledgement of the viability of nuclear power. Nations including France, India, Romania, Russia, China, South Korea, and Japan have already embraced nuclear power development, suggesting that nuclear taboo may, in fact, be at an end.

Nuclear power, like natural gas, is cheap and clean relative to conventional sources. Unlike natural gas, with its broad range of applications, however, nuclear is solely used for electricity generation. Even if nuclear power does become a primary source of electricity generation in the future, its use is likely not to crowd out natural gas.

 

Natural Gas and Its Market
Natural gas maintains the lowest carbon intensity and noncarbon emissions among fossil fuels. Natural gas produces roughly half the carbon dioxide of coal, one fourth of the carbon monoxide, and even smaller fractions of sulfur and nitrous oxides. Oil is highly viscous, making it relatively difficult to extract from poor geological environments, a problem natural gas does not face given its low viscosity. Unused gas is generally pumped into empty oil and/or gas formations for storage, or into active oil formations to bolster well pressure.

North American shale formations are providing substantial production increases through the use of hydraulic fracturing (fracking) and horizontal drilling techniques. Domestic production has increased every year since 2005, from 23,456,822 million cubic feet then to 26,176,700 in 2009. Though these issues have remained at the center of the natural gas buzz, not all the buzz is good.

Fracking involves pumping hydraulic fluid into rock formations under pressure in order to fracture the rock and release additional quantities of gas. Fracking fluids are charged with posing potential hazards to local water supplies, and the process has garnered a number of forceful complaints. With vast domestic shale formations located throughout the nation, however, exploration and production firms don't necessarily have to drill in densely populated areas.

Note that our referenced numbers are for the domestic energy mix, as opposed to the global data. Whereas oil and coal are easily transported, natural gas is primarily disseminated to end users through a series of pipeline networks. Pipelines may cross national borders in certain instances, and compressed natural gas and liquid natural gas is transported via ship and truck in small quantities, but supply routes are generally immobile. Given the nature of the pipeline and the time and cost associated with developing pipeline infrastructure, natural gas remains a highly regionalized energy source. This regional framework has made the shale plays all the more relevant to U.S. natural gas markets.

While Production has been consistently increasing, demand has decreased. This was due, in part, to a weak economy and to mild seasonal temperatures over the last year, which materially impacted natural gas consumption on account of its use as a peak electricity-generation source. We know that demand isn't being staved off by prices. Wellhead prices are down nearly 50% from the natural gas peak of late 2008, causing storage to sit at record-high levels.

Decreased demand, like the expansion of production, places significant downward pressure on prices. Despite this, investors should consider that, on account of its low cost and broad applicability, irrespective of its application as the sole bridge fuel going foreword, natural gas use is likely to increase.

Investors should also understand that, despite natural gas' recent downward trend, its market is an inherently cyclical one. When supplies expand, surpluses can develop, as has been the case in recent years. These surpluses create downward pressure on prices, detracting from the profitability of exploration and production firms. Operations are pared back in response to falling prices, but because exploration and production is extremely capital- and time-intensive, production can not be quickly ramped up to respond to increasing demand. This inevitably creates for a shortage situation. Lagging production does not allow supply to keep up with demand. Prices increase and exploration and production firms expand operations, perpetuating another round of the cycle.

The combination of moderate weather, poor economic health and uncharacteristically strong production have allowed for a prolonged downturn in the natural gas cycle. If long-run projections are correct, substantially expanded electricity consumption will offset demand drivers that have created recent downward price pressure. In the near term, the nation will operate under a natural gas surplus, but the resulting sustained price decrease only bolsters natural gas' viability as a cheap, clean and abundant alternative to current constituents of our energy mix.

In spite of falling consumption demand for natural gas and suppressed prices, pipeline construction soldiered on. Though pipeline expansions were not quite as high in 2009 as a year prior, the EIA recorded an addition of nearly 3,000 miles of pipe at a cost of $9.9 billion. These additions are still well above the domestic average over the last decade, and, given the tumultuous market conditions, highlight the industry's positive long-term outlook for natural gas.

How to Invest and Why
Because the natural gas market is highly sensitive to a broad variety of political, social and economic events, even mild changes in weather, political sentiment, or consumption patterns can have disproportionately large impacts on prices. Its leveraged nature makes the market an inherently volatile one and subject to speculation.

Several ETFs attempt to deliver the price performance of natural gas through the use of futures contracts.  United States Natural Gas (UNG) invests in near-month natural gas futures contracts trading on the NYMEX in an attempt to proportionately track the price of natural gas. On many levels, market liquidity and the absence of carrying costs make using futures a better way to invest in natural gas than owning the commodity directly.

Investors should still endeavor to understand the implications of futures trading because substantial risk is involved, as performance will not necessary follow the spot markets. For instance, as of July 31, 2010, the three-year total annualized returns for UNG were down 43.26% while natural gas spot prices only lost 15.27% over the same period. Funds trading futures contracts will realize such disparities because of the mechanics of the futures market. UNG invests in near-month futures contracts, and, as each month draws to a close it has to "roll" its position forward. Effectively, the fund sells its soon-to-expire position and purchases a contract further from expiry to avoid physical delivery. When the prices of those back-month contracts exceed the price of the front-month contract (known as a state of "contango"), the fund loses money each time it rolls its position. In contangoed markets, a fund such as UNG can suffer heavy losses even as natural gas prices rise, warranting investor caution.

An investment in natural gas may be a play on future prices, but could also be a play on sustained future use. Such would be the case if natural gas was to pick up use as a bridge fuel. According to the United States Department of Energy (DOE) 900 of the next 1000 power plants to be built within the U.S. will be natural gas facilities. As utilities phase out or replace old coal-fired plants, natural gas turbine-generated power is being increasingly adopted for its environmental regulatory compliance and price competitiveness.

Investors might not want exposure to the substantial near-term price volatility that plagues the futures market for natural gas, and might consider using an equity-security-based ETF.

 SPDR S&P Oil & Gas Exploration & Production ETF (XOP) focuses on a narrow slice of the energy universe, holding only U.S.-based companies that explore for and produce oil and natural gas. For a substantially higher fee, First Trust ISE-Revere Natural Gas Index (FCG) provides similar exposure, but weights vertically integrated oil and gas majors far more heavily. These majors derive a bulk of their revenues from operations outside of the exploration and production side of the industry, which is problematic for investors seeking pure-play exposure to the space.

Those looking to avoid exposure to the majors altogether might consider  iShares Dow Jones US Oil & Gas Ex Index (IEO). Unlike vertically integrated oil companies such as  ExxonMobil (XOM) and  Chevron (CVX), the companies held by this fund are primarily focused solely on the exploration and production of oil and natural gas. Overall, IEO has little exposure to midstream assets involved in refining, pipelines, and retail marketing, though we find it curious that it holds oil refiner  Valero (VLO). On the whole, this fund will provide more exposure to oil and gas price change and less revenue diversification than oil- and gas-themed funds that hold the large, integrated energy companies.

While exploration and production is risky, investment here won't necessarily be a bet on short-term price fluctuation as much as the industry expanding as a whole. In the context of changing emissions regulations, quickly exhausting traditional fossil fuels and projected expansion of electricity demand, natural gas exposure, with its low emissions profile and relatively cheap implementation, may be a good position in the long term.