Investing in today’s natural gas market

When I was an investment banker, we met with senior management all the time. The ritual before meeting was always the same. We’ve checked out the latest news, refreshed management biographies and reviewed current performance. Of course, we would also look at the market movement of the company’s stock.

At times, the company’s performance has been great… strong earnings, growing profits, and a rising share price.

Other times it was ugly. We would jokingly yell at the stock chart, “Pull up, pull up!” Like a pilot flying a plane into the ground, bad fundamentals have always resulted in a stock price falling.

What trader wants to be in front of a falling stock?

Nobody does. As they say on the trading floor, “Don’t try to catch a falling knife. You’ll just end up bloody.”

Natural gas is a perfect example.

It ran to over $13 about a year ago. Now it’s trading for less than $4. The reason for the dive is simple.

The recession is absolutely crushing demand.

Some of the largest consumers of natural gas are utility companies. They burn natural gas to generate electricity for their customers. Here’s the problem. When demand for electricity falls (due to the recession), utilities buy less natural gas.

I’m sure you’re thinking the same thing I am… “Who would be crazy enough to buy this stuff right now?”

Turns out some of the smartest investors out there are.

Just look at a recent investment Kohlberg, Kravis & Roberts (KKR). In case you don’t know, KKR is one of the largest private equity firms in the world. They practically invented the leveraged buyout… and they’ve made billions of dollars for their investors.

Just a few days ago, KKR announced that it was investing $350 million in East Resources, a privately held natural gas exploration company.

The Company owns exploration rights for more than 1.2 million acres. It is potentially gas-bearing land.

Why would KKR make such a commitment?

Why should they invest $350 million?

What do you know that we don’t know?

I had to dig for the information, but it’s all there in black and white. KKR discovered something interesting. The demand for natural gas can change very quickly. At the moment, demand has fallen and so have prices.

Supply is a bit harder to predict. You can’t just flip a switch and expect more natural gas to show up. You have to drill for it… and drilling takes time.

More interesting is the decline in new wells. How’s that for a little piece of classified information… Just a few months ago there were more than 1,600 oil rigs in operation.

Today the number is under 700.

Think about what happens when demand returns. Consumers will demand natural gas, but most rigs will sit on the sidelines. Getting the drill rigs back in the field and getting them operational will take time… not to mention the time it actually takes to drill those wells.

I think that the drop in drilling will lead to a price increase when demand returns.

And higher prices mean bigger returns for KKR’s latest investment. Take a page from the KKR Playbook and add a quality natural gas producer to your portfolio.

One I like is Chesapeake Energy (CHK). The company directly owns or has interests in more than 41,000 oil and natural gas wells. They have over 12 trillion cubic feet of proven reserves. It makes them one of the bigger players in the industry.