As you can see in the following chart, the United States Natural Gas Fund (UNG) has seen a bit of a rally over the past week in line with a surge in the commodity, after several months of losses.
This has been a very trying year for long traders in this natural gas ETF as negative returns in the price of gas as well as ongoing roll yield losses have decimated shares. In this piece, I argue that a turning point is rapidly approaching based on changing gas fundamentals. Specifically, I believe that investors should start preparing for the rally in natural gas, which, I believe, will begin within the next few weeks.
Natural Gas Markets
This year has been a very difficult year for natural gas bulls as the bearish themes at work in the fundamental data for the past few years not only continued but also accelerated in 2020. For those who track natural gas fundamentals, the clear trend in poor gas fundamentals can be seen in the weekly reported figures, with inventories underperforming the trend of the 5-year average starting in the spring of 2019.
In light of the above chart, the decline in gas prices makes perfect fundamental sense because, as inventories rise against the 5-year average, prices tend to fall.
However, while fundamentals have behaved quite poorly for several quarters, I believe that we are at a key inflection point in the data. Specifically, as you can see in the below chart, inventories have started to change more in line with seasonal averages with only 1 of the last 5 weeks seeing inventories grow at an above-average pace.
The reason why it pays to closely monitor this relationship is this: there is a direct correlation between changes in inventories and changes in the price of natural gas.
What the above chart basically says is this: if you can identify a change in fundamentals which will result in inventories changing at a seasonally-unusual pace, you can directly profit from the resultant change in natural gas prices. In other words, if you can understand where inventories are likely headed, you can profitably put on trades in natural gas.
This may seem simple, yet it is remarkably complex with several moving pieces requiring fairly accurate projection. However, at present, we are a bit in luck in that very large step changes are occurring in the fundamental data with impacts which will certainly be felt upon the supply and demand balance. One of the largest variables here is, of course, the decline in production.
The above chart shows that on a year-over-year basis, natural gas production has just entered into broad-based declines. It is important to historically frame this up to get an idea as per the possible impacts upon price. For example, the last time we witnessed a change of shrinking production to the point at which year-over-year declines was seen occurred in the middle-to-late part of 2016. Here is what happened to price throughout the prior adjustment.
The reason price rallied during this time period was simple: production was declining, and price needed to increase to the point where additional production was incentivized so that the market could be balanced.
We are entering another such period. Production is in free fall, and the EIA expects this weakness in production to continue and accelerate through next year.
And in conjunction with this decline in production, the EIA is anticipating that the spot price of natural gas will rally nearly 60% over the next 12 months as the market rebalances.
All this said, the natural gas trader needs to closely monitor gas production going forward since it will be one of the largest variables causing unseasonal changes in the balance (and therefore, likely be a driving force of price change as seen in one of our first charts of this section).
As a potentially bearish offset, the demand side is showing unusual weakness due to the ongoing coronavirus impact upon industrial demand.
This decline in demand has been keenly felt in the commercial sector where total consumption remains below the 5-year average.
And unfortunately, exports, a prior saving grace of the balance, have taken a tumble as the coronavirus has impacted global industrial demand.
Despite the general bearish demand side of the balance, losses in production will likely more than offset the seasonal changes in demand. For example, total consumption is running about 5 BCF/d below the 5-year max for this time of the year, while the EIA is expecting nearly 10 BCF/d of production declines through year-end. When you couple this with the fact that the worst of the demand impacts of the coronavirus have likely been felt (with employment returning and general business actively slightly surprising to the upside as of this week), the balance shifts more into the favor of the bulls.
I am quite bullish a natural gas at this time due to the decline in production at such a rate that it will very soon outpace declines in consumption. However, UNG has some instrument-specific factors which require me to attach a few caveats to my bullishness.
This year, the prompt price of natural gas has fallen by 21%. However, on a year-to-date basis, UNG is sitting on a whopping 39% loss at the time of writing. How can an ETF which purportedly tracks and holds the front natural gas futures contract dramatically underperform the actual price change of natural gas? The answer is roll yield.
UNG is an ETF which holds the front month contract of natural gas futures and then shifts its exposure into the second month futures contract two weeks prior to expiry. After expiry, the second month contract becomes the front month contract, and the roll process continues. This is a simple and straightforward method of giving exposure to futures contracts.
What is not simple and straightforward, however, is the subtle changes in the prices of natural gas. Specifically, if you closely examine the relative performance of the price of natural gas futures versus the spot price of natural gas, you’ll notice a small, but compounding difference through time. This difference is due to something called convergence.
After the expiry of a commodity futures contract, something very interesting occurs: the financial futures contract becomes a physical commodity as firms make or take delivery of the underlying commodity upon which the futures contract is based. For example, after the Henry Hub futures contract expires, firms which held futures contract positions into expiry exchange the physical gas.
If you were to look at the current spot price of natural gas and compare it to current front month futures contract, there is a slight difference in price. At present, the spot price of gas is actually a small bit above the front-month futures contract. However, on average, the market is in contango, which means that the front contract is typically below the spot price. In the chart below, I have taken the average difference between the front month futures contract and the spot price of a natural gas by the day in the month for the past 10 years.
What this chart shows is that, on average, natural gas futures contracts tend to be priced above the spot level of natural gas. However, by the end of the month (when the front month contract expires), this difference shrinks to be basically zero. This is the “convergence” which I mentioned earlier – futures contracts converge to the spot price by the end of the month because futures contracts become the spot commodity after expiry.
This is roll yield in a single picture. Since natural gas futures tend to be priced above the spot level of natural gas and since futures converge to the spot level through time, roll yield is largely negative for UNG. UNG is holding futures contracts which are converging towards the spot price by declining in value during a typical month. This means that it is slowly, but surely, seeing gradual erosion in the value of its shares on average. This year has dramatized the point in that UNG has underperformed the spot price of natural gas by nearly 20%.
This somewhat lengthy explanation of roll yield is to serve a point: roll yield is a big deal to understand and monitor while trading UNG. Since UNG is holding the front month futures contract, roll yield will be a big factor of returns since the front contract is where most of the convergence occurs. At present, the math suggests that, in a typical year, UNG loses about 12-14% per year to roll yield.
Due to these persistent losses, I suggest that investors stay out of UNG’s shares until momentum actually shifts to the upside once again. For example, if natural gas just trades sideways for a few weeks before moving up once again, UNG is likely to see losses from roll yield. To combat this, I suggest only trading UNG when it has hit a fresh 1-month high because this simple method will allow you to capture the fundamental trend while protecting capital from roll yield losses.
The natural gas supply and demand balance is shifting to the bullish side as production declines at a faster pace than losses in demand. Roll yield remains a significant factor dragging down shares in UNG, which means that investors should strategically allocate capital to the ETF. I suggest entering UNG only after price hits a fresh 1-month high to protect from the converge of futures contracts to spot price.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.