2 Graphs Every Energy Investor Needs to See

Alex Dumortier, CFA, The Motley Fool

"Nat gas is down under $2. Oil was $100. If a few years ago you told Charlie Munger or me that oil vs. natural gas would be 50:1 ratio we would have asked you what you were drinking."
- Warren Buffett, 2012 Berkshire Hathaway Annual Meeting.

With this quip at last weekend's Annual Meeting, Berkshire Hathaway CEO Warren Buffett highlighted an issue that energy investors have been pondering for a few years now: How are natural gas prices so low, and how long are they going remain this low? For some investors -- and I've heard some of my Foolish colleagues make this argument -- buying natural gas producers when the commodity is at a cyclical low looks like a good bet. While that may turn out to be the case, I'd be very careful before putting money on the felt to bet on a cyclical upturn in gas prices in an industry undergoing huge secular change.

What goes down, must come up
First, if you're not familiar with the concept of mean reversion, I like to summarize it as "what goes up, must come down, and vice-versa." When a price series is mean-reverting, it exhibits peaks and troughs that oscillate around an average value, which appears to exert a gravitational pull on prices that stray too far away. Inflation-adjusted natural gas prices appear to exhibit some measure of mean-reversion, according to a statistical test I performed on a monthly price series dating to 1960 (for the statistics wonks, the p-value was 6% -- not quite the 5% level of significance you typically look for, but pretty good all the same.)

If you graph those prices over the past 10 years, you can eyeball this phenomenon, as price increases alternate with declines with an average value somewhere between $5 and $10:


Sources: U.S. Energy Information Administration, author's calculations.

Sources: U.S. Energy Information Administration, author's calculations.

However, the tendency appears to break down at some point around 2008 and 2009, as prices remain lower, for longer than normal. What's happened since then? Why are prices depressed, and why haven't they recovered yet? The answer lies in the fact that the natural gas industry -- in the U.S., in particular -- is undergoing change that lies outside the bounds of cyclicality and threatens to upset the yardsticks investors have become familiar with. Here's a look at what's going on:


Source: U.S. Energy Information Administration.

Source: U.S. Energy Information Administration.

After a 30-year period of stagnation that began in the mid-1970s, the recent rise in gas production can't go unnoticed. Over the past five years, annual production has increased by a quarter, as a result of the development of new hydraulic fracturing ("fracking") techniques to release natural gas from shale and horizontal drilling. When the frack changes, I change my mind (apologies to Lord Keynes).

How much new supply do these advances create? One of the figures that crops up with alarming regularity -- from the Financial Times to Wikipedia -- is an estimate according to which the U.S. may now be sitting on a 100-year supply of natural gas. However, as Chris Nelder points out in an excellent piece in Slate, that estimate looks vastly inflated once you begin take a careful look at the data. But while hype isn't useful, it isn't any more useful to deny that the combination of fracking and horizontal drilling represent a "game-changer" that creates a structural, rather than cyclical, change in the economics of the industry.

Don't go fishing in shifting waters
I don't recommend stock-picking for individual investors unless they are highly committed to the craft (to a point that would qualify them as semi-professional) and they happen to enjoy it (life is too short). My injunction is even stronger with regard to trying to pick stocks in an industry undergoing structural change, the effects of which are often very difficult to predict -- even expertise provides little support. My guess is that natural gas prices can remain "depressed" longer than you can remain patient -- or solvent, if you're imprudent enough to invest on margin.

However, if I can't dissuade you from going down that road, of all the major natural gas producers -- including Cheniere Energy (NYS: LNG) , Newfield Exploration (NYS: NFX) , Apache (NYS: APA) , Southwestern Energy (NYS: SWN) , and Chesapeake Energy (NYS: CHK) -- I wouldn't hesitate in looking at Chesapeake first.

Making smart bets
Indeed, the aberrant, well-publicized breakdown in governance at Chesapeake has cast a pall over a stock that still represents a fractional interest in some choice assets. A material change in attitude (or composition) of the company's board and leadership would lift the stock to reflect the value of those assets. To my mind, that's a better bet than trying to handicap the evolution of natural gas prices - especially when you have respected value investor Southeastern Asset Management on your side. As an alternative, if you're interested in the broader energy sector, you'll want to look at The Only Energy Stock You'll Ever Need.

At the time thisarticle was published Fool contributorAlex Dumortierholds no position in any company mentioned. Check out hisholdings and a short bio. You can follow himon Twitter. The Motley Fool owns shares of Berkshire Hathaway.Motley Fool newsletter serviceshave recommended buying shares of Berkshire Hathaway and Chesapeake Energy. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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