There are two non-equity investments that I believe have huge upside over the next 5-10 years for investors with deep pockets, an implacable tolerance for pain and patience.   The first that I’ll be discussing today is natural gas. 

Ugly.  It’s the only term that comes to mind when looking at the above chart. The price of natural gas, just like the price of every asset class including stocks, bonds, and houses, is dictated by supply and demand.  Natural gas prices plummeted to such a great extent over the past few years because new technologies of natural gas extraction led to tremendous increases in supplies.  Hydraulic fracturing, known as “fracking,” brought about rapid growth in natural gas production and resulted in record levels of natural gas supplies.  All this meant one thing – much lower prices.

Beyond supply and demand, there are other important reasons leading to price decay that focus on the environmental & the political.  Natural gas, although cleaner than coal and other energy sources, is still a fossil fuel and not the answer for environmentalists to the long term clean energy solution.  Furthermore, ways in which to extract the product from U.S. grounds are also potentially harmful to the environment.  So, the Obama administration, and Democrats in general, have put restraints on the potential use of the commodity.  Even leaving environmental issues aside, Republications are reluctant to approve further federal spending of any kind due to risk a charge of “picking winners” in natural gas.

But, even given the abundant supply and other environmental/political headwinds, I believe the following 6 reasons will lead to dramatic price increase in natural gas over the next 5-10 years.  Here they are:

  1. Price.  As you saw in the chart, the price of natural gas has gotten destroyed. The ratio of natural gas to oil has never been this out of whack.  Historically, natural gas has been 10 times cheaper than oil.  Today, it’s 38 times cheaper.  The price alone should naturally mean revert even without any external help.
  2. Relatively cleaner.  Carbon emissions for natural gas are about a third that for coal and other fossil fuels.  This makes natural gas much cleaner than coal & oil, but not as clean as wind or solar.
  3. Supply.  “Natural gas prices at $2 or $3 are not sustainable.  Extremely low prices make it unprofitable for producers to extract natural gas.  If producers can’t produce it at a price above their break-even point, they simply stop producing.  And that is exactly what has happened – producers are decreasing their involvement until prices become more favorable. While oil supplies have risen considerably this year, with the number of rigs soaring since 2009, natural gas supplies are now on the decline with rig counts consistently falling.  Most people think natural gas supplies will only continue to rise, but they fail to notice that extreme record-level supplies are now on the decline due to falling rig counts, a slowdown in production, and increasing demand” (SeekingAlpha, 6/15/2012).
  4. Demand.  Rock-bottom prices and a relatively cleaner energy source have encouraged industries to change over to natural gas.  In what could be a multiyear shift, companies involved in electricity, utilities, chemicals, steel, aluminum and fertilizers are already switching from coal or diesel to natural gas—and more industries are bound to follow if it stays cheap.  Furthermore, as rising oil prices have hurt consumers and businesses at the gas pump, many have looked to natural gas as the alternative fuel. With over 10 million trucks in the U.S. consuming 35 million gallons of diesel a year (up to 25% of imported oil), a shift to natural gas could be extremely cost-efficient. With the gap between natural gas and diesel prices wider than ever, trucks (and cars) powered by natural gas are increasingly popular for company fleets.
  5. Jobs.   We obviously need them.  A September 2011 study by Wood Mackenzie says we can add 1 million new jobs in responsibly developing our own natural gas reserves by 2018 and create another $800 billion in government revenue by 2030.
  6. Major players have begun placing bets on natural gas.  Renowned investor Jeremy Grantham recently wrote, “Everyone who has a brain should be thinking of how to make money on this in the longer term.”  Jeff Gundlach of DoubleLine said that an interesting trade would be to long natural gas/short Apple (AAPL) at 100X leverage.  Billionaire investor Karl Icahn took a huge stake in natural gas producer Chesapeake.  Jim Cramer has been singing this commodities praise for months now.  The smart money is beginning to follow and the sentiment is changing.

So, how do you play it?  You can purchase natural gas related equities.  This SeekingAlpha article lists some to consider.  For my clients with the appropriate mix of account size, risk tolerance, low liquidity needs and long term time horizon, I’ve been slowly legging into small position sizes in UNG over the past several months.  UNG is the exchange traded fund that is supposed to mirror the actual price of natural gas—so a direct exposure to the commodity.

Where is the price heading over the short term?  Who knows.  This investment is a political hot potato and supply issues could make the price fall even further from the $2-$3 range where it currently sits.  But within 5-10 years, I cannot see how this price isn’t dramatically higher.  There’s too much of a need for energy independence, cost savings and jobs.  The stuff is right here in our own backyard and the calls for its use will increase during the next escalation in already high oil prices.

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