The natural gas economy is a long-term play

The story of the natural gas market is as old as time itself. It is a story of the grand commodity cycle. A commodity goes from oversupply and cheap prices to rising demand and ultimately tighter supply and high prices. Then those high prices inspire new production, causing a glut of supply. 

Of course, the glut usually brings in new demand and economic growth trying to take advantage of that demand, and the story begins once again. The backdrop of that story is huge economic growth and opportunity for those who recognize the pattern.

 In fact, this type of situation could be called an era. The era of the natural gas economy has just begun. It also means that low prices will inspire new uses and ultimately higher prices in the long run.   

 It was not too long ago, 2003, when former Federal Reserve Board Chairman Alan Greenspan warned that our declining production of natural gas was putting the economy at risk.  He said, “We’re going to see some erosion in a number of macroeconomic variables” if gas prices stay high. He said that one of the biggest threats to our economy was our inability to produce enough natural gas and warned that we would lose jobs and manufacturing, and we would not be able to compete in the global economy. We had to build terminals to import natural gas or it would spell economic doom.

Of course there is an old saying, ‘high prices cure high prices.’ They built a better mousetrap thanks in part to the genius of George Mitchell, and the fracking revolution began. Instead of economic doom, an abundance of supply meant a coming economic boom. Instead of peak gas, we now have supply that could last hundreds of year. Yet that does not mean prices always will be cheap. 

Natural gas prices started to tumble as producers not only exceeded old production levels but produced natural gas at record levels. Instead of a shortage, we had a glut and supplies that should last 100 years or more. In fact, we saw prices fall from an all-time high of $15.78 per mmBtu in 2005 to a low of $1.90 in 2012. 

Of course, with many gluts, there is a sense that prices will stay low forever. In 1998 when crude oil prices fell toward $10 per barrel people thought they could go to $5. Yet low prices spur demand and in some cases much faster than people think. Like China that built an economic explosion on cheap oil, the United States is building an economic powerhouse on cheap natural gas.

Of course, crude oil is part of a global market and natural gas has always been a domestic commodity. That, like all things, can change. While the shale gas and oil revolution has been a boom in the United States, the rest of the world has not had the same success. Other countries like China, Japan and those in the European Union have tight supplies and are more dependent on gas and have the same worry that Alan Greenspan had nearly a decade ago. They worry that their inability to have cheap natural gas may put their economies at a competitive disadvantage. While prices in the United States have been hovering just above $3, we can see $15 in Europe, and as high as $16 to $17 in Japan. China during a cold blast hit over $20.  At some point this will be a negative for the global economy, and market forces will demand that U.S. gas finds its way on to the global stage.  More importantly, that type of price discrepancy creates opportunity that will be filled by those enterprising businesses creating the ability to turn the abundant domestic supply into liquefied natural gas more easily transported overseas. 

In fact, despite the history being on the side of a market up-swing, many think that natural gas will stay cheap forever. Based on the forward curve we have seen the prices of natural gas stay relatively flat (see “Cheap gas forever” below). Yet already the demand for natural gas is rising, and much faster than many people expected. We already are on track for exporting more natural gas than many thought possible. The U.S. Energy Department has approved exports of liquefied natural gas from five terminals since 2011 and comes as U.S. natural gas output continues to hit record highs and prices remain below those in Asia and Europe.

Another area where natural gas demand will soar is power generation. With gas being much cleaner than coal and companies worried about the watchful eye of the Environmental Protection Agency, many will switch to natural gas a lot faster.  Reuters News reported the expansion of the capacity to generate power from natural gas this decade may be far greater than expected, as companies race to build projects to reap the benefits of low prices and replace retiring coal-fired plants.  Energy companies are expected to add about 55,000 megawatts of gas-fired plants by 2020, according to a Reuter’s survey of major utilities and power producers. That is about 20,000 MW more than current government estimates.

And that is just the beginning. We are seeing a huge move toward using gas as a transportation fuel. General Motors is coming out with a natural gas car that can switch to conventional gas. Warren Buffet is thinking of using natural gas to power his locomotives.

The point is that the natural gas cycle could mean that U.S. prices for gas are way undervalued. There is apathy and disbelief that prices can rise, and that is a plus for investors. We saw the same type of apathy when natural gas was cheap in the last decade, but those that bought cheap in the long end of the curve were richly rewarded. 

 Manufactures are embracing this market because they know that they can lock in contracts for cheap natural gas for years to come — they are locking in now because this is a great deal. Speculators should have the same long term outlook.

Exploiting opportunities

It is one thing to see the writing on the wall and conclude that a basis trade will develop between the cheap domestic price of gas and the much more expensive price of gas overseas, and quite another to devise a trading strategy to take advantage of it. 

 The easy way to play it is to sell near-term contracts and buy further out contracts to take advantage of an expected steepening of the forward curve, or to buy far out natural gas calls. The problem is that leaves you vulnerable to short-term weather spikes and that far out options at this point are thin. We have had a very hard time buying anything farther out than 2015, and you have to be patient as there are only a few out there to make that market. Yet determination and open price orders should start to get filled if you are diligent and patient. 

The other way to trade it is spread outside of the current season. By buying options farther out in the curve, say 2015 or 2016, and selling options close in, but not subject to immediate fundamentals, you should find a way to take advantage of the long-term global demand growth. 

Even if supply continues to grow, the possibility that demand will exceed expectations and the possibility of increased inflation and production costs should make the long end bullish. If you are well capitalized, you can buy five to eight years out in the future and write puts and calls and collect premium on the short end of the curve  with  delta-neutral option positions to try to help monetize your position. You have to keep the options with offsetting positive and negative deltas so that the position of delta is zero.  With the current low volatility in natural gas, this should not be too hard but may become more complicated if volatility increases in the future. You have to remember that puts always have a negative delta ranging from –100 to zero, while long calls always have a positive delta ranging from zero to 100, so it is important to keep the delta equally weighted with the thought process of staying long the natural gas future for the long hall. As the market rises, and if you play it wisely, you should be able to start augmenting your futures position with added equity.

Natural gas has gone from boom to bust. Get ready for the next boom!

Phil Flynn is senior energy analyst at The Price Futures Group and a Fox Business Network contributor. He is one of the most recognized energy market analysts.

About the Author

Senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor.