The Wrong Way to Bet on a Natural Gas Recovery

Natural gas has plummeted to its lowest levels in a decade. Although low prices for natural gas are causing problems throughout the energy industry, contrarian value investors look at the plunge as a potential buying opportunity.

Yet before you put your hard-earned money into one of the most obvious plays in the natural gas space, you need to do your due diligence. Once you do, you'll find that a huge coming spike for a popular natural gas ETF isn't what it might appear to be at first glance -- and longer term, you could find yourself disappointed if you invest in it.

I'll talk about that exchange-traded fund ETF later in the article. But first, let's review where natural gas is -- and where it could be headed.

The bull case for natural gas
Few people could have foreseen the huge rise in natural gas production over the past several years. Unconventional energy plays like shale gas have greatly expanded supply well beyond what the market was prepared to see. For instance, in a typical month, Cabot Oil & Gas (NYS: COG) produced almost 55 Bcf of natural gas from its Pennsylvania Marcellus shale holdings alone. As a result, demand hasn't kept up at all, and prices have had nowhere to go but down.

But now, companies are finally starting to take steps to curtail supply. Chesapeake Energy (NYS: CHK) has shifted production away from dry gas and plans to continue doing so, with asset sales designed to raise cash. Even low-cost producer Southwestern Energy (NYS: SWN) is making similar moves, observing that gas rig counts are falling sharply and capital budget reductions are likely to follow suit. Only the absolute lowest-cost companies can afford to keep producing at these levels, as Ultra Petroleum (NYS: UPL) has done, expecting to continue ramping up its gas output even at current prices.

The ETF for you?
If lower supply leads to higher prices, then the first place many people would look for profits is the U.S. Natural Gas Fund (NYS: UNG) . Unlike many funds that own shares of companies in the energy industry, this ETF has direct exposure to natural gas prices through futures contracts. On any day when gas futures rise, you should expect to see its shares go up, too.

In fact, I can just about guarantee that U.S. Natural Gas will see its share price quadruple later this month. But that's not because I expect natural gas to jump from $2.50 to $10 -- but rather because of something we've unfortunately seen before from this ETF.

Doing more splits
Starting next Wednesday, U.S. Natural Gas will trade at four times its closing price the night before as a result of a 1-for-4 reverse split of its shares. So if you own 100 units of the ETF at $5 next Tuesday night, you'll wake up the next morning with 25 units worth $20 apiece. As you can see, the total value of your holdings will stay the same, as you'll simply have fewer shares with a higher price.

U.S. Natural Gas did a 1-for-2 reverse split less than a year ago, coincidentally again when the share price had hit the $5 level. The move bumped the shares back to double-digits for a while before they fell back, losing more than half their value since last March.

That may make sense given the drop in gas prices. But looking back further, the ETF has lost more than 95% of its value in the past five years. That's quite a bit more than the drop in gas prices from between $7 and $8 to their current levels around $2.50, and it stems from something called contango: the way gas futures markets are positioned.

I've described contango before, but to look at it from another perspective, look forward in time. Futures contracts for next year expect gas prices to rise almost 50% to the $3.60 to $3.70 range. If you invest in this ETF hoping for a 50% gain if that price recovery comes to pass, you won't get it -- in all likelihood, you'll get flat performance at best, because the rise will all get eaten up by the friction of trading in and out of monthly futures contracts along the way.

Look elsewhere
ETFs can be useful tools for investing, but only if they work the way you expect. With the U.S. Natural Gas ETF, the futures markets prevent the fund from doing its job over the long haul. You'll be better served looking for more direct beneficiaries of a gas recovery if you want to profit from it when it comes.

If you like energy plays, we've got a much better bet. Read about it right here in the Motley Fool's special free report on the energy industry and its best prospects -- it's free, but only available for a limited time.

At the time this article was published Fool contributor Dan Caplinger likes ETFs that do their job right. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Ultra Petroleum. Motley Fool newsletter services have recommended buying shares of Ultra Petroleum and Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never saps your energy.

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