Profiting from Government Intervention

You can always blame governments for screwing things up, but could there be a silver lining in Alberta's recently announced royalty grab? If anybody has been following the recent debate over increasing the provincial royalty taxes on conventional as well as tar sands production, its me. My portfolio has been highly leveraged towards all aspects of oil and gas, but primarily in North America and mostly in Canadian drillers, service companies, P&Es, and oilsands. So obviously my personal stake in Cdn. holdings have drifted lower (in spite of record oil prices!) over the last 6 months because of this gov't review. Although I don't like it, increasing royalties and changing rules has been a fact of life in many parts of the world and I'm not here to argue that there shouldn't be an increased social benefit to all this development in AB.

Oilsand companies will face higher royalties on a sliding scale with the price of oil, but most oilsands companies' stock prices haven't suffered much as oil has continued to trend higher. The same cannot be said of Ng producers especially mid- and smaller Ng producers including PEY.un, CMT, BVX, and POU. These are just a few Cdn. Ng producers that are trading at cyclical low NAV - based upon discounted proved and probable reserves. I've been selectively buying these and other names over the last year believing we've hit a low only to have one negative after another.

I'm not losing faith in the ones I've held, but after Premier Stelmach announcement yesterday there have been a flurry of announcements from drillers and P&Es that they will cut back on drilling new wells. This lack of investment may spell little growth and even production declines (horrors!) for the companies I own, but it is bullish for the intermediate price of Ng. I believe this is the time to buy the underlying commodity.
For those of you new to the Ng markets, a good primer is here:
http://canada.theoildrum.com/node/3095

The Ng markets are self correcting in a way because as the price gets too low, P&E shut-in wells or stop drilling altogether, and eventually supply goes down and the price rebounds. Ng has always been very cyclical with predictable seasonal variations (up in the winter and summer and down in the shoulder periods). Also those of you that know me, will attest to my peak oil leanings! In fact from my readings, peak gas in N.A. is already past and supply will gradually decline as the oil drum article linked above discusses. The problem in a nutshell is that all the large Ng fields in N.A. have been discovered and now we're going after the smaller pools which by definition are smaller and hence deplete much faster. In fact it's not unheard of to have depletion rates of 25% within the first year in some wells. The number of wells drilled and general investment peaked in 2006 and all this did was to have flat production and arguably a slight decline. If P&Es don't invest anymore production will decline; if they invest even less the decline will be faster. Another primer on Ng http://www.theoildrum.com/node/2157

There are other bullish factors that point to higher Ng prices. There is a rough correlation between oil and Ng prices eventhough oil is a international commodity and Ng is more of a local N.A. one. The energy content of oil compared to that of Ng is about 6:1 in terms of B.T.U.s and it should trade roughly in that range. There are some industrial users that can shift from one fuel to the other depending on price. Recently oil has been around $80 and Ng $6 so either oil has to come down or Ng should go up. Demand has been quite stable in N.A. over the years but one of the largest users of Ng are the oilsands producers as it is very energy intensive to extract bitumen via SAGD (steam assisted gravity drainage) or in the refining of bitumen into syncrude. The total amount of Ng used because of this ramp up in oilsands production may leave very little for export into the U.S.

Luckily I've found an ETF that aims to mimic the two front month contracts for Ng delivery. Its symbol on the Amex if UNG. It has reasonable volume and a market cap now of 438 million. It was launched last spring at $50 and now trades around $40 which is its NAV. Unfortunately its price and NAV doesn't match up with the quoted price for Ng, but you can look up its NAV here:
http://www.etfconnect.com/select/fundpages/etf_funds.asp?MFID=176653

So what are the negatives and why is the price of Ng depressed? There are a number of things:
1. Storage levels are at historical highs.
2. We had a mild winter and normal summer.
3. Risk of rising imports from Liquefied Natural Gas (LNG) tankers.

I believe #1 and #2 will take care of themselves given time. The weather is the weather and there's not much to do about it. #3 will take some years before it makes a real impact on the N.A. market. There are many LNG terminals planned and being built in N.A. and while they may be built, there's no guarantee that they'll have the import volumes. Europe and Asia have been very proactive about signing long term supply contracts with LNG exporters and N.A. hasn't because of its low Ng price environment. Also need I mention the two countries with the largest Ng reserves for potential export are Russia and Iran. (I think Qatar might be in there too)

Sorry for the long post, but overall I think investing in the underlying commodity is the correct play at this time and will remove company specific risk.

Hoping for a cold winter!

Des