Heat up More Than Your Home This Winter

Physician's Money Digest, Nov30 2004, Volume 11, Issue 22

The average consumer's heating bill this comingwinter is expected to be around $1000,that's up 65% from 3 years ago. As of midSeptember 2004, wholesale natural gasprices increased from about $2.50 to around $5 perthousand cubic feet—the lowest wholesale price sinceNovember 2003. According to the Bureau of LaborStatistics, since 1979 the price of natural gas has risenby 226%, while overall inflation has increased 159%.So, what does this mean to you as an investor?Natural gas is good.

Naturally Resourceful

Natural gas should be a part of your investmentportfolio, and there's more than one reason why.Following are a list of reasons why natural gas makesfor a good investment:

• Natural gas is a North American commodity.Existing natural gas import facilities can only import1% of our natural gas consumption. The rest of ournatural gas must come from wells drilled in NorthAmerica. It will take years to overcome environmentalobjections and infrastructure problems to significantly increase our import capability.

• Demand for natural gas is growing about 2%annually. Despite increased drilling, supplies havedeclined by about 2% per year over the past fewyears. The number of producing gas wells in theUnited States has increased from 300,000 in 1999 tomore than 350,000 in 2001, but average per well productivityhas declined over the same period.

• North America has added 200,000 megawatts ofnew power plant capacity in the past 5 years and 94%of this new power capacity is fueled by natural gas.

• When natural gas prices spiked 2 years ago,there was concern that existing utilities would switchfuel sources and stop burning natural gas. However,as you can see, the price/energy content value of naturalgas is far superior to oil at current prices. Insteadof switching to oil, many utilities have switched fromburning oil to using natural gas.

• At least 80% of new homes built in the UnitedStates are heated and cooled with natural gas, and today50% of all US homes are heated with natural gas.

• If oil prices stay where they are, there is plenty ofroom for natural gas prices to rise further before thecost/energy equivalent of natural gas and oil is equal.

• A number of untapped natural gas reserves inthe United States are off limits.

Hard vs Paper Assets

This is the decade to own hard assets (eg, oil andgas producing properties, real estate, commodities,etc) and not paper assets like stocks and bonds. Since1900, there have only been three 10-year time periodswhen the real return on stocks (ie, returns less inflation)was negative. All three down periods in the stockmarket began with three characteristics: low inflation,low interest rates, and high price/earnings (P/E) ratios.And in all three down periods, hard assets significantlyoutperformed stocks and bonds.

Investor heads up:

So, what do we have today? Inflation is hoveringaround 2% annually, we have near record low interestrates, and stock P/E ratios are in the mid-to-high 20s.The bottom line is that no secularbull market has ever started from this position.

If you invested $100,000 in any of the major marketindexes 5 years ago, your investment has brokeneven or is slightly underwater today—that's assumingyou haven't paid any mutual fund or other moneymanagement fees. Maybe the next 5 years will be better?If you happen to follow market sages WarrenBuffet and Sir John Templeton, you know that theyaren't particularly optimistic about the near-term outlookfor stocks.

Investor Confusion

There is no disputing that over long time horizons(ie, 20 years or longer), stocks have outperformedalmost all other asset classes. But what if your investmenthorizon is shorter than 20 years? At a recentinvestment seminar, audience members were informallypolled about their approach. They were asked ifthey viewed themselves as long- or short-terminvestors. Most people described themselves as long-terminvestors.

The audience was then asked to raise their handsif they thought long term meant 10 years or more. Noone raised their hands. Only a few people raised theirhands when asked if long term meant between 5 and10 years. Hands were raised, however, when a long-terminvestment horizon was described as one thatwas shorter than 3 years. So, even though the audienceviewed themselves as long-term investors, themajority had an investment time horizon of less than3 years, which is hardly long term by any measure.

Pointers and Benefits

If you're interested in investing in natural gas, youcan buy stocks from drilling companies, suppliers, orpipeline companies. The stocks of healthy companieshave done well and should continue to do well in thefuture. Before you decide on a stock, however, youmay want to consider making a direct investment inthe drilling and production of natural gas. You can dothis by investing in a natural gas drilling partnership.These programs can provide you with a 100% taxdeduction for the amount of your investment.

In addition, even the most conservative programsare spinning off annual cash flows of between 15%and 25%. The cash flow is also partially tax-shelteredby oil and gas depletion deductions. Some programswill distribute cash flows to investors for 25 years. Ofcourse, before you invest in a drilling partnership, youneed to know what to look for. If you've decided naturalgas is the way to go, consider the followinginvestor guidelines:

• Select a program that is structured in such a wayso that 100% of your investment is deductible onyour tax return in the year you make the investment.

• Consider a program that participates in low-riskdevelopmental drilling in areas such as the AppalachianBasin in Pennsylvania and West Virginia and thePowder River Basin in Montana and Wyoming.

• Invest in a multi-well drilling program that hasat least 10 to 20 gas wells.

• Look for a driller that has established a long andreputable track record.

• Make sure the drilling partnership has obtainedadequate liability insurance.

• Find a partnership that invests at least 25% ofthe cash needed to drill the wells.

• Don't select a program unless it converts yourinvestment into a limited partner interest so that yourpersonal liability is limited after drilling operationsare completed.

There is still time to make a direct investment in2004, and you can take the tax deduction this yeareven if you don't send in your investment check untillate December. The investment case is more compellingthan ever to invest in natural gas. Plus, yourinvestment in natural gas will help reduce the currentgas shortage in North America.

is president of Alliance Affiliated

Equities Corporation, a NASD-registered broker/dealer specializing in tax-advantaged investments.

He welcomes questions or comments at 800-453-5155 or office@aaeconline.com.

David P. Dyer