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Beware of These Natural Gas Victims

Falling prices amid a growing glut are spreading lots of pain


The plunging price of natural gas has severely punished those who have been invested in nat gas stocks during the past year, but this sector is just one of many victims of the commodity’s flagging price. Coal stocks, certain utilities, railroads and alternative energy stocks are also among those hit to varying degrees by the slump in natural gas in recent months.

Therefore, investors in these areas need to be keenly aware of developments relating to natural gas supplies in the months ahead.

The oversupply of natural gas is nothing new, but the stakes are getting higher according to a grim prediction set forth in last week’s Barron’s (subscription required). Natural gas has suffered a two-pronged attack on both the supply and demand fronts, and according to Barron’s, the picture may be about to get worse. The combination of elevated supply from hydraulic fracturing, or “fracking,” technology and the reduced demand caused by the warm winter has brought inventories to record levels for this time of year.

The result, says Barron’s, is the possibility that the U.S. could run out of storage capacity as soon as October — which would depress prices further. Barring an unforeseen occurrence — the article cites a hurricane or record summer heat as possibilities — this is likely to remain an issue throughout the summer.

Click to Enlarge
Storage capacity data is available here. Note the level from which the seasonal storage increase is starting now compared to one year ago.

Anyone thinking of establishing a long position in these sectors must keep a watchful eye on this issue as the summer progresses. While each of the market segments discussed below has been hit hard and — in many cases — are rich with stocks that have fallen to tempting valuation levels, the upside may be capped as long as the potential exists for storage to become maxed out. At the same time, however, depressed sentiment has raised the possibility of a positive surprise later in the year.

The Victims List

Here’s the quick-and-dirty rundown on the sectors vulnerable to falling natural gas prices. While industry-specific issues have affected these groups, the natural gas collapse has been a headwind for all five:

Natural Gas and Coal: No surprise here — these are the most obvious victims. Natural gas stocks have already felt the pinch, as the First Trust ISE-Revere Natural Gas Index ETF (NYSEARCA:FCG) has returned -25.53% since its peak on April 1, 2011, compared with a gain of 4.99% for the S&P 500 Index in that same interval. While this sector’s performance has been ugly, it has been saved to some extent by the oil exposure of many natural gas drillers.

The same can’t be said for coal, however. Power companies have switched to natural gas due to its lower price, weighing on domestic demand for coal and sharply depressing prices. This trend has been evident in market performance: Since July 22, the Market Vectors-Coal ETF (NYSEARCA:KOL), which is also pressured by the possibility of tighter environment regulations, has returned -36.63%.

Utilities: Although this sector has less direct sensitivity to the price of natural gas than the first two, it’s nonetheless suffering in the current environment. Since natural gas prices are one of the key determinants of power prices, utilities have seen their profitability erode. While certainly not the only issue weighing on utility stocks, this has contributed to the sector’s underperformance so far in 2012.

Year-to-date, the Select Sector SPDR-Utilities ETF (NYSEARCA:XLU) has returned -2.11%, more than 13 percentage points behind the broader market. Certain utilities with higher exposure to the dampening effect natural gas is having on power pricing have performed even worse so far this year, including Exelon (NYSE:EXC), which has fallen 9.1%, and Public Service Enterprise Group (NYSE:PEG), off 7.4%.

Railroads: Railroads don’t have direct exposure to natural gas, but they do ship coal — lots of it. According to the Aaron Levitt’s April 5 InvestorPlace article on coal, CSX (NYSE:CSX) and Norfolk Southern (NYSE:NSC) generate about 30% of their total revenue from coal shipments, while Union Pacific (NYSE:UNP) gets around 22%. Not coincidentally, the three stocks are off 17.5%, 13.6% and 7.5%, respectively, from their 52-week highs. Rail stocks have delivered excellent returns in the past two years, but the weakening demand for coal is starting to hurt.

Alternative Energy: Who needs alternatives when natural gas at its lowest level in nearly 10 years? That’s the question investors seem to be asking, if the 12-month returns of a few select ETFs are any guide:

  • PowerShares WilderHill Clean Energy ETF (NYSEARCA:PBW) : -49.76%
  • Market Vectors Uranium+Nuclear Energy ETF (NYSEARCA:NLR): -23.97%
  • PowerShares Global Wind Energy Portfolio (NASDAQ:PWND): -41.97%
  • Market Vectors-Solar Energy ETF (NYSEARCA:KWT) : -72.56%

Again, this is an area that has its own set of unique challenges, as InvestorPlace writer Larry Meyers points out regarding solar stocks, but it’s going to be difficult for these sectors to embark on a sustainable turnaround as long as natural gas inventories are limiting their ability to compete on price.

How Should Investors Play This?

Since the groups affected by natural gas prices are very diverse, no uniform strategy can easily be put in place. For investors in utilities and rails, the watchword is caution: Be aware of the situation and the potential that a sharp increase in natural gas inventories over the summer could lead to additional underperformance.

With coal and natural gas stocks, the story is somewhat different because both are more directly affected by the supply issue. This is absolutely one of those times when investors need to be able to discern the difference between a longer-term change of direction and a short-term trading rally.

Exhibit A: the jump in coal stocks earlier this month. After languishing for over a month, many shares rose over 10% on March 14-15. Now, three weeks later, the majority have given back this gain and then some, with many now at fresh 52-week lows. The lesson: Plenty of trading rallies are still ahead even as the bad news continues — just don’t mistake them for a longer-lasting turn.

Despite the current negative news flow, a phenomenal trading opportunity could be on the way in the months ahead. Positive fundamental news on the natural gas front, when it finally occurs, should be just the catalyst to spark a rally in the coal and gas stocks that have lagged in recent months. If the U.S. does indeed have a hotter-than-normal summer, or if a hurricane strikes the Gulf, the full-capacity scenario may not play out as Barron’s outlined. That would likely spark an outstanding rally in these downtrodden sectors.

How outstanding? Consider the returns of KOL in the following three time periods:

  • 3/13/08 – 6/18/08: 46.82%
  • 3/2/09 – 1//8/10: 270.34%
  • 8/26/10 – 1/5/11: 57.70%

However, until the fundamental outlook for natural gas changes and/or these stocks break above their downward-sloping trendlines, coal and nat gas stocks need to be traded conservatively, with tight stops and an aggressive approach to profit-taking on rallies.

Article printed from InvestorPlace Media,

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