The Commodity Investor: Chesapeake Energy Offers Grip On Natural Gas Market
Natural gas output ticked up in August.
Investors should have a clear understanding of the complexities and volatility of the energy commodity before jumping in.
Natural gas is the second-most important commodity in the energy complex after crude oil, in terms of both volume and usage. In addition to being one of the most actively traded energy commodities, natural gas (or “natgas” as traders call it) has several important uses.
First, it’s an important component in electricity generation: Many electric power plants use natural gas (alongside coal and, to a lesser extent, nuclear power) to generate electricity. Second, it has many critical industrial applications and is a feedstock for important products such as plastics, fertilizer and even gasoline. Finally, natgas is a key commodity in many households; indeed, natgas is used for water heaters, stoves, furnaces and even barbecues.
However, unlike oil, which has been one of the top-performing commodities this year and last, natural gas has been one of the worst performers. This may seem paradoxical given its wide uses and strong demand from industrial and residential segments; however, it’s important to look at the supply side of the equation, which has led natural gas prices to historic lows.
Natural Gas: An Idiosyncratic Market
Before delving into the recent price fall, it’s important to understand that natural gas is a unique commodity that tends to move independently of comparable commodities such as crude oil or coal. In addition, natural gas is known as one of the most volatile resources in the commodities complex. This is why it’s referred to by many traders as the widow maker, because many traders can’t handle the volatility, and this includes sophisticated traders.
Take the example of Amaranth Advisors. Amaranth was one of the top commodity hedge funds in the market, with more than $9 billion in assets under management. In 2006, the hedge fund lost $6.5 billion when it got caught on the wrong side of a trade in natural gas futures. This was one of the biggest trading losses in the history of commodities markets. As a result, the hedge fund was forced to shut down.
Natural gas is subject to unexpected mood swings; when you look at a historical price chart for the last 10 years, you quickly identify several sharp peak-to-trough reversals, the sharpest being in 2005 right after hurricane Katrina, and another in 2008, after the collapse of Lehman Brothers. It’s not uncommon for prices to jump from $5 mmbtu (million British thermal units) to $15 mmbtu and then back down to $7 mmbtu in a matter of a few weeks. Many traders and investors can’t handle this volatility, which is why it’s critical to understand what you’re getting into.
Natural Gas Drivers
Natural gas prices are driven by several factors. First, natural gas is increasingly being used as a substitute for oil because it’s a cleaner-burning fossil fuel, as it produces almost 30 percent less carbon dioxide than its crude counterpart. As a result, this gas/oil ratio is increasingly becoming an important price driver.
Second, the abundance of supply may now be the most important driver in the market, which is largely responsible for depressed prices. Over the last several years, energy companies invested billions of dollars in technological innovation such as hydraulic fracturing of shale, or “fracking,” in order to more efficiently extract natural gas.
This drilling and extraction technology became so successful so quickly that it unlocked vast amounts of natural gas that was previously unreachable. This has pushed to historic lows approaching $2/mmbtu. It’s safe to assume that prices may remain at these depressed levels for several years to come.
Finally, another key driver that makes natural gas quite unique is the weather. Because natural gas is used for heating purposes, seasonality plays an important role in determining prices across the year. When the weather is hot, demand for natural gas decreases. When it turns cold, more people use natural gas to stay warm. This is why many sophisticated natural gas traders study weather patterns before placing a natural gas trade.
Investing in Natural Gas
Natural gas is not for the faint of heart; however, it can provide some unique investment opportunities for the discerning investor. If you want to add natural gas to your portfolio in anticipation of a price rebound, I recommend Chesapeake Energy Corporation (NYSE:CHK).
Chesapeake is one of the most active companies in the North American natural gas market. Chesapeake owns more than 45,000 wells across the United States and produces more than 3 billion cubic feet of natural gas or natural gas equivalents per day. Chesapeake is active in Texas, Louisiana, West Virginia and Pennsylvania, which gives it a broad geographical footprint in some of the key natural gas regions in the United States.
Disclosure: The author doesn’t have any positions in the stock mentioned.
Amine Bouchentouf is a partner at Parador Capital LLC, an institutional advisory firm focused on commodities and emerging markets. He is the author of the best-selling “Commodities For Dummies,” published by Wiley. Amine is also the founder of Commodities Investors LLC, an advisory firm dedicated to providing insightful information on all things commodities. He can be reached at amine@commodities-investors.com.
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