Contrarian opportunity in natural gas

This ETF holds equally-weighted positions in 30 stocks involved in the out-of-favor natural gas sector.

By TheStockAdvisors Mar 2, 2012 10:54AM

Kevin Burke/CorbisBy Mark Salzinger, The Investor's ETF Report

Over the past year, stocks of the natural-gas producers have lagged both the broader energy sector and the stock market as a whole by a wide margin, reflecting investor concerns over low gas prices and robust production.

However, both price and supply pressures on producers could improve in 2012, making natural-gas stocks a compelling contrarian opportunity.

One of the factors backstopping the price of natural gas is actually how very cheap gas has been recently.

After reaching a high of $13.50 per million BTU (British thermal unit) in mid-2008, natural gas prices collapsed, reaching about $2.50 per million units by September 2009.

Since then, natural gas prices have never risen above $6 per million units. Recent weakness stems from both robust production and a mild winter in much of the United States.

At such levels, natural gas becomes an attractive alternative for large-scale consumers like utilities, mass transit operators and owners of large vehicle fleets, who otherwise use relatively higher priced coal, gasoline or diesel.

Another factor that should support prices is pending production cuts from some producers. Chesapeake Energy, the No.2 U.S. natural gas producer, recently said it would further cut its production of dry gas wells in half, after already cutting production by a third from its average level in 2011.

With natural gas futures in contango (the longer the futures contract has to expiration, the higher the price), it is difficult for investors to make money rolling futures contracts over month to month. So we think futures-based ETFs and ETNs that attempt to track the actual price of natural gas are a poor choice.

Instead, we think the best contrarian play on natural gas is to invest in the stocks of producers.

Consider First Trust ISE-Revere Natural Gas (FCG), which invests in 30 stocks of energy producers who derive a substantial portion of their revenues from natural gas, and whose shares exhibit strong correlation to natural gas prices.

Stocks are also ranked on measures of valuation and profitability; the portfolio is made up of equal-weighted positions in the 30 energy producers with the best scores.

The portfolio includes integrated oil & gas majors such as ExxonMobil (XOM), leading producers EOG Resources (EOG), EnCana (ECA), Apache (APA) and Anadarko (APC).

The ETF also holds positions in smaller producers with a more narrow focus like Stone Energy (SGY) and SandRidge Energy (SD).

FCG's median market cap is $9.1 billion. Mitigating the risk of smaller producers is FCG's emphasis on valuation: its price-to-book value ratio (1.6) and price-to-cash flow ratio (4.8) are lower than the broad energy sector (1.9 and 6.5, respectively). FCG's expense ratio is 0.64%.

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