All Gassed Up

Fed Governor Bernanke's testimony last week, along with the continuing slow motion collapse of the bond insurers, made it clear the Federal Reserve will continue to print money like it is going out of style in a vain attempt to forestall the coming implosion of our financial house of cards. Sooner or later, this flood of money will lead to hyperinflation here in the US. The above picture is an actual photograph of a German woman burning paper money in her furnace in 1923 because it would cost more than the pile of money at her feet to buy firewood, so it actually made more economic sense to use her money to heat her house.

Hopefully, you are taking steps now to safeguard your financial future, including buying gold through one of the various methods discussed in previous posts. Today I'd like to spotlight a different commodity which has just broken out of a two year congestion period - natural gas. As oil prices have gone through the roof lately, natural gas prices had stayed relatively low. Every previous time this has happened in history, natural gas prices have risen to "catch up" to the rise in oil prices. So what's the best way to play this?

The most conservative investors can play the rise in gas prices by buying shares in the natural gas exchange traded fund (symbol: UNG), which mimics the rise in price of natural gas futures contracts, without the extra risk and hassle of margin calls. Unfortunately, since this ETF is based on futures contracts, there are no long-term options available, although there are currently options that run out as far as October 2008.

A good single company stock play on natural gas is Chesapeake Energy, one of the largest natural gas companies in North America. After a huge run up over a five year period, it too had been in a period of consolidation over the last two years, but has recently broken out and up of that pattern, just like natural gas itself. It has a very strong balance sheet and a number of politically prominent board members, including former US Senators. Most invitingly of all, over the last few years the CEO and other insiders have regularly bought millions of dollars worth of Chesapeake shares with their own money.

It is important to keep in mind that natural gas has one critical difference with other energy sources like crude oil, coal, or heating oil - it cannot be transported by sea except in liquid form - and the liquid form requires special processing terminals in seaports. North American has very few such terminals, and efforts to build more inevitably run into the NIMBY (Not in My Back Yard) syndrome from community residents and environmental activists. That is why natural gas prices soared so high when the Gulf Coast was threatened by Hurricane Katrina a few years ago. This provides a natural competitive barrier against large amounts of imported foreign gas for Chesapeake.

A higher risk strategy is to purchase Chesapeake call options. Regular readers know I prefer to buy the longer-term LEAPS to smooth out short term price volatility (see previous posts for a detailed explanation of how options work). I bought some January 2010 $60 strike price call options two weeks ago and they are now up about 40%, but there should be more room to run in the near future.

The obvious danger here is that Chesapeake shares get dragged down with the general market if there is a large stock decline, which is why I prefer the longer-term options. Another way around that is to use the highest risk strategy of buying natural gas futures contracts directly. This is difficult for the small investor because natural gas is a very large contract with some of the highest margin requirements of any futures contract. So the small investor who wants to go this route is best advised to purchase options on natural gas futures contracts instead. This has the added advantage of not requiring any margin and hence not being subject to margin calls.

One final thought - I find it extremely humorous when Senator Clinton tries to make the case that Obama will not be able to withstand the "Republican attack machine" that will be unleashed on him if he should become the Democratic nominee. The reality is that anyone who can withstand the Clinton attack machine has nothing to fear from the "vast right wing conspiracy!"