Can Natural Gas Prices Recover?

BOSTON (TheStreet) -- Natural gas prices, long thought to be correlated to oil, have diverged in recent years, fueled by lower production costs and new forecasts of greater-than-expected global shale reserves. As shown in the graph below (with futures prices displayed for 2012 dates), prices for both fuels were severely hurt by the Great Recession, yet crude oil prices have been on a steady ascent, while natural gas is stagnant.

One of the oft-quoted pieces relating to the relationship between the two fuels is a white-paper from 2007 put out by the Federal Reserve Bank of Dallas. The report, "What Drives Natural Gas Prices?", discusses various metrics used in the energy industry to relate the pricing between natural gas and oil. One metric, called the 10-to-1 rule, states that a barrel of oil should be worth 10 times that of natural gas.

With crude oil currently trading for around $101/barrel, this "rule" would indicate that natural gas should be trading for around $10. With natural gas trading for around $4.30, the metric is either completely inaccurate or natural gas is wildly undervalued. In the chart below, it's apparent that while the 10-to-1 rule was fairly consistent from 1992 through 2008, the recent 25-times ratio deems this rule invalid in today's environment.

Why has there been such a dichotomy between the pricing of the two fuels? For one, technological innovations stemming from horizontal drilling and hydraulic fracturing have made it possible to extract shale gas more economically. These lower costs of shale-gas production have led to increased supply (in the past decade, shale gas production has increased 10-fold), leading to the depressed pricing over the past several years. And according to a recent EIA report, global shale reserves are significantly higher than once thought.

Many energy companies that rushed into shale gas production are now using the same technology to extract oil. The latest Baker Hughes rig count, a popular gauge for the oil and gas industry, showed a 76% increase in active oil rigs over last year, while gas rigs have fallen 10%. With oil at $101/barrel, it's not shocking, given the profits that can be made in oil versus gas.

But can natural gas prices rebound? It might take a while, but it's probable. Over the long term, natural gas demand should meet the increased supply. On the latest quarterly call, ExxonMobil ( XOM) CEO Rex Tillerson predicted that "natural gas will be the fastest-growing major energy source in the world and will overtake coal as the second-largest global energy source behind only oil in the next 20 years." And as companies turn to higher profits in oil, natural gas supplies should come down over time, which can only help improve the supply-demand imbalance.

Natural gas, which is the cleanest of all the fossil fuels, also appears to have governmental support. President Barack Obama, in a recent update on his proposed energy plan, called "the potential for natural gas enormous." A new energy bill backed by T. Boone Pickens, titled "The New Alternative Transportation to Give Americans Solutions Act," or NAT GAS act for short, would provide federal incentives for natural gas. The plan, which appears to have broad bipartisan support, would provide purchasers and manufacturers of natural gas vehicles with credits. If passed, the bill could put natural gas back in play.

So how does an investor take advantage any potential increase in the price of natural gas? To get direct exposure to any change in gas prices, the best investment is the United States Natural Gas Fund ( UNG), an exchange traded fund that invests in futures contracts on natural gas. For those interested in an ETF tied closely to natural gas stocks, take a look at the First Trust ISE-Revere Natural Gas Index Fund ( FCG). The fund 's top five holdings, as of May 25, were Cabot Oil & Gas ( COG), PetroHawk Energy ( HK), Southwestern Energy ( SWN), Stone Energy ( SGY) and Range Resources ( RRC).

Equity research manager Chris Stuart, CFA, joined TheStreet Ratings after working as a senior investment analyst with Merrill Lynch covering small-cap equity and alternative investment strategies. Prior to that, Stuart worked for One Beacon Insurance as an actuarial analyst and at H&R Block as a financial adviser. Stuart earned his bachelor's degree in finance from the University of Massachusetts, Amherst. He holds a Chartered Financial Analyst (CFA) designation and is a member of the Boston Security Analysts Society (BSAS) and the CFA Institute.

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