Natural Gas Prices Expected to Rise, But Value Is Not in the Commodity (UNG, FCG, SGY, COG, HK, SWN, SD, XOP, WTI, EQT, PXJ, BHI, NBR, HAL, FTI, DO)

Late Wednesday night, natural gas prices inexplicably dropped by about 8% on the NYMEX, well after the exchange had closed for the day. It took only a few seconds for the price to bounce back up, but the experience — a “mini-flash crash” perhaps — is so far unexplained.

Natural gas prices at the Henry Hub have been rising, coming within a hair’s breadth of $5.00/million BTUs, a level last seen in August 2010. The low prices have slowed the growth in onshore drilling for natural gas in the US, at the same time that it is encouraging some utilities to look at natural gas as a fuel for baseload power generation.

The abundant supplies of US natural gas available throughout the drilling technique known as hydraulic fracturing, or ‘fracking’ or ‘fracing’, has swept the industry, leading to massive amounts of new gas discoveries and production, as well as to lower prices. The industry needs prices to rise to around $7-$8/million BTUs in order for it to make a decent profit, but with prices stuck below $5, that day appears to be well into the future.

Investing in natural gas purely as a commodity play is best left to experienced traders. There are, of course, other ways. Four funds we’ll look at here are United States Natural Gas Fund (NYSE: UNG), First Trust ISE-Revere Natural Gas Index Fund (NYSE: FCG), SPDR S&P Oil & Gas Exploration and Production (NYSE: XOP), and PowerShares Dynamic Oil & Gas Services Fund (NYSE: PXJ).

United States Natural Gas Fund (NYSE: UNG) invests in near-month natural gas NYMEX futures contracts. In the past 52-weeks, the fund has lost more than -25% of its NAV, but with $1.9 billion in assets it is the largest natural gas fund available. Because it invests only in near-month contracts, UNG must roll-over its contracts every month, in effect selling its about-to-expire position and purchasing new contracts for the following month. In a contango market, where future-month contract prices exceed near-month contract prices, such a strategy loses money every month. Thus, even when natural gas prices rise, UNG can lose money because the future contract price will rise at least as quickly as the current price.

Why own such a thing? Primarily as a hedge against inflation and almost no correlation with equity prices. Pretty small beer, all things considered. UNG is trading at $11.93 at about mid-day, within a 52-week range of $10.02-$17.68.

The First Trust ISE-Revere Natural Gas Index Fund (NYSE: FCG) tries to replicate the ISE-Revere Natural Gas Index by investing at least 90% of its funds in the common stock of that index’s companies. The fund’s top five holdings are Stone Energy Corp. (NYSE: SGY), Petrohawk Energy Corp. (NYSE: HK), Cabot Oil & Gas Corp. (NYSE: COG), Southwestern Energy Co. (NYSE: SWN), and SandRidge Energy, Inc. (NYSE: SD). These five comprise 18.95% of the fund’s holdings. The fund’s assets total $586 million and it is trading today at $21.19, within a 52-week range of $14.39-$23.75. In the past year, the fund has gained more than 30%.

The SPDR S&P Oil & Gas Exploration and Production (NYSE: XOP) invests in equities  of companies that explore for and produce oil and natural gas. The fund’s top five holdings are Cabot, W&T Offshore, Inc. (NYSE: WTI), Petrohawk, EQT Corp. (NYSE: EQT), and Southwestern Energy. The fund’s assets total $908 million. The fund is trading at $56.55 today, within a 52-week range of $37.44-$65.76. Over the past year, the fund has gained about 42%.

The PowerShares Dynamic Oil & Gas Services Fund (NYSE: PXJ) tracks an equity index called the Dynamic Oil Services Intellidex. It invests at least 80% in common stock of oil and gas services companies, and may invest up to 90% of its assets in the Intellidex index companies. Its five largest holdings are Baker Hughes Inc. (NYSE: BHI), Nabors Industries, Ltd. (NYSE: NBR), Halliburton Co. (NYSE: HAL), FMC Technologies, Inc. (NYSE: FTI), and Diamond Offshore Drilling, Inc. (NYSE: DO). The fund’s assets total about $247 million and it is trading today at $23.35, in a 52-week range of $13.98-$26.84. The fund has gained about 66% in the past year.

A reasonable conclusion from this quick survey is that investing in natural gas producers pays off nicely, but the real gains have come in the services sector. Holding natural gas futures has very limited appeal, but plenty of investors do it.

Growth in the services sector is likely to continue as drilling picks up both onshore in the US and offshore in the US Gulf of Mexico. As for the producers, Cabot, Stone, and Petrohawk are all involved in natural gas plays that produce significant amounts of liquids. And that’s where the money is, not in gas. Gas may become worth more over the next year or so, but the price differential between liquids and gas is never likely to close again.

Paul Ausick