🔥 Your Guide To Investing In Natural Gas, A Bridge Between Fossil Fuels & Renewable Energy?
Again, not to be confused with gasoline used in cars! Natural gas mainly consists of methane, but there are other compounds mixed in as well. Natural gas can actually be extracted from many different sources, like coal and shale deposits, trapped between layers of rock underground, or even collected from landfills and animal waste. Natural gas found underground is a non-renewable resource, since it’s formed from dead organic matter over millions of years. This is generally referred to as a fossil fuel. However, natural gas extracted from landfills and processing sewage and waste water is considered a renewable resource, since we can continually keep making it. Furthermore, it burns much cleaner compared to other fossil fuels, producing fewer carbon emissions. Removing and using animal manure and food waste to produce natural gas prevents gas emissions that would have otherwise escaped into the atmosphere from landfills. With existing natural gas infrastructure in place, the switch to renewable natural gas could certainly be a cost-effective short-term solution as we transition to renewable energy, a bridge to a more sustainable future.
Also worth noting that transporting natural gas in its gaseous state requires pipelines, which means countries need to rely on domestic production to meet demand, or import from other countries. Alternatively, Liquified Natural Gas (LNG) is an easier and safer form of the commodity for transport, allowing global access. This is done by cooling down the gas until it becomes a liquid. LNG has its own market, and is arguably a different product than natural gas in its gaseous state, since natural gas is focused on domestic production, consumption and exports to nearby countries via pipelines, whereas LNG is focused on global exports and imports.
What Can It Do For You
🧺 Portfolio Diversification. As always, adding commodities to your portfolio can help diversify and lower risk. Adding natural gas to your portfolio means owning an asset that tends to act differently to other asset classes, and even to other commodities.
💰 Profit. Although prices have been on a downward trend for a number of years, generally speaking, natural gas prices tend to fluctuate seasonally due to changing consumer demand in response to weather conditions. This means that this cyclical pattern can provide opportunities for speculative returns. Generally, there are a number of long-term trends that can act as support for natural gas prices. These include: growing global demand for LNG (particularly in developing markets), and the general trend of transitioning away from fossil fuels, which could benefit natural gas. That being said, there are a number of risk factors that can put downward pressure on prices. These include: substitution by renewable sources of energy, and increased production from multiple sources of natural gas.
🎢 What Happened During Those Price Spikes?
Basically, it all comes down to supply and demand,
- 2001 — This first big spike was caused by increased demand, whereas on the supply side, years of lowered production have led to a shortfall. Shortly after, a weakened economy sent prices tumbling down since demand pretty much dropped.
- 2005 — This bigger spike is believed to have been attributed to a series of adverse geopolitical and weather events, like Hurricane Katrina hitting the gulf coast, conflict in the Middle East, and others. These events have led to reduced supplies in key areas, and have also ramped up market speculation, essentially causing panic in the market.
- 2008 — This spike is mainly attributed to Hurricane Gustav, with shut down natural gas production in the gulf coast, causing supply disruptions and market speculation. However, shortly after, the 2008 financial crisis hit, leading to decreased demand. On top of this, there were advancements in creating more efficient and cost-effect extraction techniques, as well as the rapid utilisation of alternative sources of natural gas like shale, basically rock formations with natural gas trapped inside. Because of these advancements, though there have been price fluctuations in the years after, price levels have been relatively low due to continually increasing production numbers.
What Affects Natural Gas Prices
Since the US is a big producer and consumer of natural gas, and has an active financial market for the commodity, we’ll be talking about factors related to the US gas market. That being said, these factors do somewhat affect global gas prices to some extent.
- 🇺🇸 US Natural Gas Domestic Supply. As the biggest producer and consumer of natural gas, the US is able to produce more than enough to meet its needs. This past decade has seen increases in production due to developments in more efficient and cost-effective extraction techniques on a number of alternative sources of natural gas, such as shale rock. As US production continues to increase, natural gas prices generally decreases.
- 💧 Alternative Natural Gas Sources Supply. Developments in more efficient extraction systems from a number of natural gas sources, such as shale and biogas (natural gas produced from processing landfills, animal excrement, sewage, etc.), have led to increased production. Going forward, the Liquid Natural Gas (LNG) market is increasingly becoming more prevalent. This essentially converts natural gas into a liquid form, making it safer and easier to transport over longer distances without the need for pipelines. This means that natural gas can be exported over longer distances to countries further away, making natural gas an increasingly global commodity. As such, this can lead to more supplies in the market as more and more countries are able to offer natural gas in the global markets, potentially lowering gas prices.
- 🏦 Economic Activity. Generally speaking, demand for natural gas (and therefore its price) correlates to economic activity. Greater economic activity usually means increased activity and spending in commercial and industrial sectors, which would also usually mean increased demand for natural gas. This is especially true in industrial sectors, since natural gas is not only used as fuel, but also as an input material to make products like fertilisers and certain pharmaceuticals.
- 🗡️ Disruptive Geopolitical Events. This factor can have an effect on global natural gas prices. Aside from the US, Russia is the second biggest producer and consumer or natural gas, and exports a significant amount to nearby Eastern European countries. This acts as leverage for Russia in political negotiations, since they are able to cut off supplies at any point. Announcements of this nature can certainly cause uncertainty in the global natural gas markets.
- 📦 Stock Levels. Stored excess natural gas in underground storage facilities plays a key role in moving natural gas prices. This is because since demand for natural gas is seasonal, during periods of low demand, excess natural gas can be stored and helps put a floor on prices to prevent it from going too far. During periods of high demand, stored natural gas can be released to help meet the increase in demand should it exceed production capacities.
- 🌩️ Weather/Seasonality. Weather can definitely impact the price of natural gas. In the supply side, adverse weather conditions like hurricanes can disrupt natural gas production, as mentioned above. In the demand side, commercial and residential demand tends to be seasonal, with peak demand occurring during colder winter months (to heat buildings and homes), and lower demand during the summer months. Occasionally, unexpected weather conditions can lead to a sudden short-term increase in demand.
- 🔁 Substitution. Natural gas is one source of energy. There are other alternatives to choose from depending on price, such as coal, oil, nuclear, and renewable energy. So, if natural gas prices rise too high, it may incentivise consumers to switch to others, lowering demand, and therefore lowering its price. Similarly, if natural gas prices are low compared to the others, this may incentivise consumers to switch to natural gas, increasing demand, and therefore increasing its price.
Where Is Demand Coming From?
As seen in the chart below, electricity generation makes up most of US natural gas consumption, but there are also other sectors that consume a significant amount as well. Here are the major industries that need it:
- ⚡ Electric Power. According to the EIA, 36% of US natural gas consumption is for electric power, with natural gas providing 31% of all electric power consumption.
- 🏭 Industrial. Industries use natural gas as fuel for heat, and as an input material to produce a range of products like fertilisers and chemicals. This sector represents roughly 33% of US natural gas consumption.
- 🏘️ Residential. Natural gas is also used in homes and buildings for heat. Other functions include cooking and drying clothes. This sector represents roughly 16% of US natural gas consumption.
- 🏬 Commercial. Similar to residential, natural gas is used to heat buildings and water in the commercial sector, as well as a number of other functions too. This sector represents roughly 11% of US natural gas consumption.
- 🚌 Transportation. Natural gas is also used as fuel for vehicles (in a compressed & liquefied form), and as fuel to operate compressors that moves natural gas through pipelines. This sector represents roughly 3% of US natural gas consumption.
The Case For Natural Gas
Like other commodities, not only can natural gas serve as a portfolio diversification tool & a hedge against inflation, but it can also provide opportunities for speculation and profit, particularly due to the cyclical seasonal price movements in response to fluctuating consumer demand.
Overall, long-term outlook for natural gas includes a number of positive trends that can support prices. Firstly, demand for natural gas is expected to increase steadily over the next couple of decades, and is expected to the be strongest-growing fossil fuel, according to a McKinsey report. This is especially true with the liquid natural gas (LNG) market, where global demand is set to increase, particularly from countries in the Asia Pacific. LNG has essentially turned natural gas from a domestic commodity to a truly global commodity, allowing it to be transported safely and more efficiently.
Furthermore, this increase is demand is expected to be partially attributed to the general trend of countries transitioning away from fossil fuels and into cleaner sources of energy. As developing nations move away from coal, natural gas presents itself as a cost-effective and somewhat cleaner source of energy compared to coal. Government policies that support carbon neutrality can certainly support natural gas prices as they move away from coal.
The Case Against Natural Gas
There are a couple of risks involved if you want to get involved with natural gas. Firstly, although renewable natural gas can be obtained through organic waste, according to WWF, roughly 80% of natural gas extracted from the US is from underground. In other words, a fossil fuel. Natural gas can certainly be a bridge between fossil fuels and renewable energy, but only if production scales up dramatically. As countries focus on achieving sustainable targets, they may put limitations on natural gas in favour of other renewable sources of energy. Which brings me on to my next point…
The energy market is increasingly becoming more crowded as the market share for renewable sources of energy becomes bigger. Though developing markets may transition away from coal and into natural gas, developed markets may transition to renewable sources of energy, which can lower demand for natural gas, and therefore its price.
Last but not least, increasing production from numerous sources of natural gas can certainly keep prices subdued in the long term. From shale to oil and associated gas wells, supplies are expected to increase to meet growing demand.
Popular Ways To Invest In Natural Gas — Pros/Cons of Each
If you’re still confused about how any of these work, refer back to our basics newsletter for a refresher.
- Natural Gas ETFs. There are a number of ETF options that you can choose from, depending on the level of exposure to natural gas prices, as well as risk levels. These ETFs are traded on stock exchanges, so they’re very easy to buy and sell. Nevertheless, they’re very easy to buy and sell. However, there are no assurances that you actually own physical natural gas. Depending on which broker you go with, you may be charged with trading commissions. ETFs also charge an expense ratio, or management fee that gets taken out of their total holdings and is then reflected on your account. Whichever ETF you choose, be aware of the fine print — the risks and costs.
- Natural Gas Stocks. These are shares of companies with exposure to natural gas prices. That being said, many of these companies also have exposure to other products, like crude oil, since natural gas can be extracted alongside these products. This means that you aren’t necessarily fully following natural gas prices since there are other factors that come into play. You may want to consider looking at the company’s annual reports (especially operational costs), portfolio of what facilities they have, and potential exploration plans.
- Natural Gas Futures Contracts. A binding agreement traded on futures exchanges between two parties where they agree to buy/sell natural gas at a specified time in the future with an agreed-upon price. The Chicago Mercantile Exchange (CME) actually offer two different types of natural gas futures products. One is natural gas, and more recently, the CME has launched a Liquified Natural Gas (LNG) futures contract, mainly focusing on the export market. Because you are using a significant amount of borrowed money, even small price changes in natural gas can either lead to massive profit, or massive losses beyond what you paid for, potentially leaving you in massive debt. They are certainly high-risk and not recommended for beginners. Further, fees associated with futures trading include broker commissions, and exchange/clearing fees.
TL;DR — Is It The Right Investment For You?
As always, it depends on what your aims are. Although natural gas prices have been declining over a number of years, generally, it follows a cyclical seasonal pattern due to fluctuating consumer demand. As such, natural gas can not only be used as a portfolio diversification tool, but it can also provide decent speculative returns.
Overall, there are quite a number of factors that can support natural gas prices in the long term. Generally, demand for natural gas, especially liquid natural gas (LNG) is expected to increase in the long-term, especially as developing markets transition away from coal, and as countries focus on sustainable sources of energy.
However, renewable natural gas makes up a minority of the natural gas extracted in the US, which could restrict its adoption by other countries that have stricter carbon neutrality policies. Furthermore, natural gas competes with other renewable sources of energy, which is expected to infringe on the market share for natural gas. Last but not least, increased production from multiple sources of natural gas is expected to keep prices relatively subdued in the long-term.
🧺 If you are considering adding natural gas to your portfolio or bundling it with a number of others, you may want to consider doing dollar-cost averaging (regular investments over time) to build your natural gas position so you can take advantage of the volatility in the market.
💰 If you are considering trading natural gas for speculation and profit, you may want to monitor the factors that affect natural gas prices mentioned above. The EIA provides weekly updates on production, consumption, stock levels, and other bits of information, which can provide a snapshot into the supply and demand dynamics at that point in time. In addition to monitoring the factors mentioned above, you may also want to consider performing some technical analysis on natural gas’ price chart to help consolidate trends and patterns to help with your decision.
As always, if you are unsure, check in with a professional financial advisor before making any moves.
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