Marcellus Shale Bulls

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"What's Goldman up to this time, another oil flip?"

I give up with the banks.

About three weeks ago, Goldman Sachs released a report identifying 15 stocks hedge funds should buy now. Four of the companies are involved with natural gas—including BP, Marathon Oil, Chevron and Chesapeake Energy.

Why, then, did Goldman Sachs go short natural gas just this past Monday? As it explained in a statement:
NYMEX natural gas prices have rallied 12% in the past three weeks, largely driven by strong cooling-related demand for natural gas on the back of significantly warmer-than-average temperatures and exacerbated by the still high nuclear outages.

However, these factors are transient in nature and their support to generation demand for natural gas will likely diminish the coming weeks as the weather normalizes and nuclear power plants come out of maintenance.

So is it long or short natural gas? Or both?

This is why I don't listen to the big banks any more.

Another Goldman Oil Flip?

What makes me question the natural gas call was Goldman's quick flip on oil. I'm sure you remember this—on April 12, Goldman told investment crowds to sell oil:

While prices are back at levels of spring 2008, supply-demand fundamentals are significantly less tight. We believe that there are fundamental differences between now and the spring of 2008: Both inventories and spare capacity are much higher now and net speculative positions are four times as high as in June 2008.

And it was right. Oil pulled back. But notice the use of "significantly less tight" because all of a sudden, it disappeared weeks later—on May 6, Goldman screamed for investment crowds to buy oil:

We continue to see fundamentals tightening over the course of this year, likely pushing prices back to recent highs by next year. It is nevertheless important to reiterate that while we saw recent prices as having risen above the levels consistent with underlying near-term supply/demand fundamentals, we continue to believe that the oil supply/demand fundamentals will tighten further over the course of this year and likely reach critically tight levels by early next year should Libyan oil supplies remain off the market.

Consequently, it is important to emphasize that even as oil prices are pulling back from their recent highs, we expect them to return to or surpass the recent highs by next year. . .

It changed from a short-term trading call to a long-term trading call, but didn't explain the rationale clearly. In fact, it looks as though it removed the "less tight" argument of April 12 to "tighten further" in three weeks.

Come on, Goldman.

How Long Until It Changes Its Mind on Natural Gas?

Do yourself a favor and ignore Goldman's call. Get excited about the future of natural gas. We are—and we're not the only ones. . .

Chevron recently acquired 228,000 acres of Marcellus.

Exxon Mobil just paid $1.69 billion for two privately held natural gas companies—including Phillips Resources and TWP Inc.—allowing Exxon to also pick up 317,000 of exploration acres in the Marcellus Shale region—that's after Exxon spent $30 billion to buy natural gas company, XTO Energy and following its $700M purchase of Ellora Energy for a piece of the Haynesville Shale.

Just why did Exxon buy them? Because, says Exxon, the companies had proved reserves of 228 billion cubic feet equivalent natural gas.

And thanks to the Middle East brouhaha, Investor Relations VP David Rosenthal believes unrest in oil-exporting companies in Northern Africa and the Middle East is cause for "the high crude prices that have helped drive his company's interest in natural gas."

Not only does this further cement Exxon's interest in natural gas; it strengthens our reasoning for getting into the Marcellus region right now—with a $10 stock that banks should be jumping all over.

Some of the biggest oil companies in the world have made large investments in Marcellus. Shouldn't you follow them?

John Pinkerton, chairman and CEO of Range Resources, says he wouldn't be surprised to see the oil majors taking over shale assets. . . And that could mean our small $10 stock stands a good chance at seeing a takeover.

Don't Miss this Boom

As we've noted in these pages in the past, the Marcellus has become a once-in-a-lifetime opportunity that could generate good returns not only for you, but also for the Marcellus "boomtowns."

If drilling grows at a 20% clip per year, the area could easily add another 20,000 jobs by 2015. According to the area's Chamber of Commerce, more than 50 new gas-related businesses have moved into the area: "It's the biggest economic development story in our entire history."

How to Trade It

One of the best ways to trade the Marcellus boom is to buy beaten-up companies involved in the Marcellus boom, like Exxon Mobil (NYSE:XOM).

While you can always buy the underlying stock and let it run, here's another way to do it: You can buy LEAPS options.

Say you wanted to buy exposure on XOM two years out. You could buy the January 2013 XOM 80 calls around $8 (or $8 x 100 shares, or $800). That's cheaper than paying $8,000 for the same 100 shares. A LEAPS option allows you to take a position in an option without risking too much and without the threat of near-term price decay.

While it may sound confusing, it's easier than you think.

LEAPS are basically options that have a longer-term lifespan (between one and three years). And they're an effective, low-cost, high-return way to play the market if you think an asset is poised for upside over the long term.

LEAPS also give you much more margin for error, because you don't have to make the correct call right away (within weeks or months); you just need to be right over a period of one to three years.

Because you're playing longer-term options, the prices are generally cheaper. In fact, if you play LEAP options with an at-the-money strike price, your outlay is usually 10% to 15% of the underlying share price for controlling the same number of shares.

How's that for lower risk and more leverage?

While the most you can lose is limited to what you invest in the option, the gains can be terrific. That's because options thrive in volatile, unstable markets. So when an underlying asset moves, the consequent move on options like LEAPS is often magnified.

You can use LEAPS to:

  • diversify your portfolio for a significantly lower cost than by just investing in shares;
  • lower your cost, versus what you'd pay for owning shares outright (this consequently lowers your risk);
  • hedge against short-term company/market risks. (For example, if a company reports bad earnings and you own shares, you take an immediate hit; but holding LEAP options gives you added risk protection, as there will be more time for your position to recover.)

Options are probably the easiest and most cost-effective way to make money these days—especially in this market.But I've been doing this gig long enough to know options intimidate and confuse people, which is why I've put together a free tutorial for anyone who shutters when they hear the words "put" or "call."

This video includes basic lessons on options and should clarify the most-common misconceptions for investors new to the options game. And again, it's free to you.

You'd be doing yourself a great disservice not to look.

Take good care,

Ian Cooper
Analyst, Wealth Daily

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