With all of the focus on shifting investments from riskier assets – like stocks – to safer ones, resource companies have enjoyed increased attention and investment. That should come as little surprise right now: investors who are forced to keep their cash in the market are focusing on stocks that are commodity-driven. But as a potential downside emerges in natural gas, gain potential is being created in a big way…

I listened to several presentations at the Enercom conference this week. One important message from companies operating in the Gulf of Mexico: in the wake of the Minerals Management Service reshuffling, the regulatory framework is in chaos. Nobody among the regulatory bureaucracy seems to want to take responsibility for approving any drilling permits. This is needlessly ruining many investment plans and hurting the region’s labor market.

Producers of goods and services, whether they are in oil and gas, farming, or manufacturing, or transportation, keep prices low (in contrast, the Fed is cooking up new ideas to raise prices of goods and services by printing and distributing new, unearned claims on the economy’s production). Producers respond to shifts in consumer preferences by expanding or contracting capacity.

It looks like we’re facing a temporary supply glut in natural gas (in storage, not necessarily in the ground). Now that we’re past the peak of cooling season in North America, producers might find themselves competing for storage at lower and lower prices.

This is getting reflected in the price of the front-month natural gas futures contract, recently breaking below $4 per million BTU (MMbtu):

Here is a chart of the spread (or difference) between the front month price and the price for the 12-month futures contract. This is far more important for producers because they rely heavily on hedging to mitigate price risk. The chart shows that as recently as a year ago, producers could sell forward their gas at a $3 per MMbtu premium to the spot market. Recently, this premium fell to just a 50 cent premium:

This collapsing premium will drive the gas rig count lower. Only the very lowest-cost producers will be able to drill gas wells profitably with prices for delivery in mid-2011 at $4.50 per MMbtu.

I’m looking at short ideas in natural gas service industry — specifically, drilling and completion — because I don’t think the stocks have yet discounted how sharply earnings could fall in a weaker rig count environment.

If you’re interested in taking the short-side trade against natural gas servicers, not all opportunities are created equal. I’m still working on my due diligence right now, but I’ll share my latest insights with you in the near future.

Best regards,
Dan Amoss, CFA
Penny Sleuth

September 1, 2010

Dan Amoss

Dan Amoss, CFA, is a student of the Austrian school of economics, a discipline that he uses to identify imbalances in specific sectors of the market. He tracks aggressive accounting and other red flags that the market typically misses. Amoss is a Maryland native, a graduate of Loyola University Maryland, and earned his CFA charter in 2005. In spring 2008, he recommended Lehman Brothers puts, advising readers to hold the position as the stock fell from $45 to $12. Amoss is managing editor of the Strategic Short Report.

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