For traders in the ProShares UltraShort Bloomberg Natural Gas (KOLD) ETF, it’s been a solid year as seen in the following chart.
While long traders of KOLD certainly have enjoyed strong returns over the past month, I believe the party is almost over. Specifically, it is my view that over the coming months, we will see natural gas fundamentals strongly shift to the bullish side resulting in losses for long KOLD traders.
Natural Gas Fundamentals
To set the stage for this section, let’s start out with a quantitative relationship which helps call changes in the price of natural gas.
In the above chart, I have taken the past 10 years of natural gas data and graphed the correlation between 52-week changes in inventories and 52-week changes in price. This economic relationship is straightforward and makes a lot of sense: when inventories fall on a seasonally-adjusted basis, prices tend to rise over the same time period.
What the above chart shows is the 5-year range of inventories and the distance between the 2020 and 2019 line is the data points which go into the prior chart.
As you can see in this chart, inventories have been climbing against the levels of the prior year for most of this year. This growth in inventories has been bearish, as clearly evidenced by the weakness seen in prices throughout this year.
The key drivers of this bearishness are two-fold. First off, gas demand was very poor during the tail-end of winter which resulted in weak heating demand.
And secondly, the spread virus impacted total industrial demand as commercial activity dwindled.
There is no denying these bearish data points: a poor winter combined with economic weakness has resulted in inventories climbing on a seasonally-adjusted basis which is propelling prices lower. However, if you’ve been watching the latest data, there’s an interesting pattern at work – inventories have started to contract on a seasonal basis over the past month.
As you can see, since late May, inventories have started to increase at a slower pace than 2019 as well as the 5-year average pace in basically every single week. In other words, something is happening beneath the surface in gas fundamentals which is leading to tightening inventories (and therefore will likely lead to rising prices).
There are actually two separate stories going on here. First off, summer demand is set to be very strong this year with many demand-centers reporting record temperatures. NOAA is calling for hot weather to persist which will lead to additional electric power demand.
The data is a bit lagged, but what this following chart essentially shows is that we are going to see another record power-burn summer with electric demand remaining above the 5-year average.
It is important to remember that this additional power demand is actually adding to a long-term pattern of growing gas demand. In other words, not only is more power generation relying on natural gas but also the summer is likely to remain hot which means that even greater amounts of gas will be used.
And the second variable impacting gas inventories is the massive collapse in drilling activity.
There is no way to bearishly sugarcoat this data – drilling activity and production is in collapse.
It is instructive to go back and study the history of natural gas prices as it relates to production levels. In the above chart, you can see that the last time gas production shifted into year-over-year declines was in the middle of 2016. The chart below shows this time period.
Put simply, prices respond to weakening production. The economic reason is pretty straightforward – if supply shifts downwards and demand either remains the same or increases, prices rise. Given that demand is recovering from the pandemic and given that we’re set to continue to see a record summer power burn, the decline in production becomes even more worrisome for the gas bears.
I am quite bullish natural gas. I believe that the price of gas is set to rise on weakening production and that now is a good time to buy gas. However, I must give a few caveats for trading KOLD, specifically due to its methodology.
KOLD is a relatively straightforward ETF which is shorting the Bloomberg Natural Gas Subindex at 2 times leverage. This basically methodology has KOLD shorting the front natural gas futures contract until a few weeks before expiry, at which point it rolls exposure into the next contract. For example, here are KOLD’s current holdings.
The problem with this simple approach to natural gas futures is the high degree of roll yield associated with this trade.
Roll yield is a highly misunderstood financial concept which is actually fairly simple. Roll yield is basically the gain or loss that investors accrue when they hold exposure to futures contracts and those contracts converge towards the spot price of a commodity.
The following chart captures the entire roll yield problem as it relates to gas futures.
What this chart shows is that during a typical month, the front contract starts off about 1.5% above the spot level of natural gas. In other words, there’s a difference in price between the physical spot price of natural gas and the futures contract which delivers the physical commodity a few days or weeks into the future.
The chart shows a very important relationship: through time, the difference between spot prices and futures prices erodes such that it’s basically zero at the time of settlement of the front contract. If you do the math, this chart basically shows that on average, if you held the front contract from the start of a month until expiry, you would on average lose 1.5% per month.
In actuality, this loss of 1.5% never shows up in a trading account (which is why most investors are unaware of this near-constant toll on their portfolio). Rather, this loss can only be perceived if you do the math comparing the return you earn in your futures positions versus the return of the underlying spot price of natural gas.
How the math basically works is that if the spot price of gas went up 5% during the month, the futures contract which narrowed towards the spot price would have only gone up about 3.5% during that month. This slight difference in performance may seem negligible when seen on a single month basis, but annualized, this potentially represents losses for long gas traders in the territory of 16-20% per year.
The great thing about KOLD is that it is short gas futures. Since the math shows that the front contract tends to fall by about 1.5% during a month and since KOLD is exposed to the front contract for some of the month, it is capturing some of this convergence. So, I must concede this point to the gas bears trading KOLD: roll yield is absolutely working in the favor of long KOLD traders since a long KOLD position is short gas.
However, ultimately, I believe that gas fundamentals are bullish and therefore the outright price of KOLD is likely going to fall. You may still earn positive roll yield from shorting the contango convergence, but I believe the price of gas is likely to rise resulting in larger losses for KOLD traders.
Natural gas fundamentals have been very bearish this year as poor winter demand was followed by weakening economic conditions. Gas fundamentals are decisively turning as a strong summer demand is eating away at diminishing supply due to production cuts. KOLD is benefiting from roll yield as it is short futures which are converging towards the spot by falling.
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.