How to Make Money From a Natural Gas Bounce

One of the hottest topics among investors recently has been the boom in the energy industry. Everywhere you look, new unconventional energy sources like shale plays and oil sands are springing up, transforming local economies and raising a host of opportunities and concerns.

Yet amid all this excitement, you can't ignore one reality: Natural gas prices have fallen back near decade lows, and many investors who expected to cash in on the energy boom through their portfolios have been sorely disappointed. It's not enough to pick any natural-gas investment; you have to make sure you own the right one.

Later in this article, I'll point you in the right direction for a lucrative gas investment. But first, it's important to avoid some pitfalls that many have fallen into before.

When the simple answer doesn't work
Perhaps the most obvious choice for natural gas investors is the United States Natural Gas ETF (NYS: UNG) . Unlike natural gas companies, this ETF tracks the price of natural gas directly through futures contracts. When gas futures rise, the daily price typically rises along with it.

Of course, as natural gas has fallen in recent years, this ETF hasn't given investors good returns. Yet what may be surprising is just how bad those returns have been. For instance, over the past year, the price of natural gas has fallen from around $4.50 per million BTUs to $2.50, a drop of 44%. But the natural gas ETF has lost even more -- about 53% of its value. That's considerably worse.

Over longer periods of time, the disparity is even sharper. In September 2007, gas fetched about $6 on the spot market, making today's price about 58% lower. But the ETF has lost more than 90% of its value in that time.

The problem? A phenomenon in the futures markets called contango, in which traders expect higher prices to come in future months. For instance, right now, futures for next January price gas at about $3.50 -- 40% higher than current levels. That higher price represents a continual erosion of value for ETFs that use futures-based strategies. So while the ETF does a good job in the short run between rolling futures contracts, it presents serious problems for longer-term investors.

Do ETFs work?
But the downsides of United States Natural Gas don't mean that every ETF is flawed. You just have to know what you're getting yourself into with an ETF investment.

A stronger alternative is First Trust ISE Revere Natural Gas. Rather than futures contracts, the First Trust ETF owns companies that produce natural gas.

Now don't be misled: Many of the stocks in this ETF aren't solely or even primarily gas-focused. For instance, ExxonMobil (NYS: XOM) and Chevron have made big acquisitions to boost their natural gas footprint. Exxon even boasts the status of the largest natural gas producer in the country -- and the company said last month that it saw gas as the key to Exxon's future in the next several decades. But those companies obviously give you plenty of exposure to oil as well. That's a problem if you think that gas prices could rise at the expense of oil rather than alongside oil prices.

But even for individual stock investors, that's increasingly a problem. Natural gas stalwarts Chesapeake Energy and SandRidge Energy (NYS: SD) have taken great strides in shifting exposure from gas to oil and other liquids. SandRidge in particular foresaw exactly the current situation happening when it bought Arena Resources two years ago, boosting its oil exposure. Those moves, however, make it tough for investors to find a pure-play gas stock.

Look hard enough, though, and you'll still find them. One reason that Range Resources (NYS: RRC) and Ultra Petroleum (NYS: UPL) have taken such hard hits so far in 2012 is precisely because they remain heavily invested in natural gas. The harder they fall, the further they'll rise once natural gas bounces off its lows and heads higher. And the First Trust ETF gives you exposure to both, along with Exxon, Chesapeake, SandRidge, and a host of other players in the industry.

Be smarter about energy
Value investors have longingly looked at natural gas for years, yet it's continued to go even lower. Eventually, though, demand will rise to accommodate current massive supply -- and at that point, the sky could be the limit for the clean-burning fuel.

Natural gas drillers and producers are obvious candidates, but we've got another exciting natural-gas stock you may not have considered. Join the thousands who've already found out its name and more about the company in The Motley Fool's special free report on natural gas, but don't wait -- get it today.

At the time thisarticle was published Fool contributor Dan Caplinger hates when investments don't do their job. 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 Chevron, Ultra Petroleum, Range Resources, 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 always feels energetic.

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