As you can see in the following chart, the ProShares Ultra Bloomberg Natural Gas ETF (BOIL) has taken a bit of a beating throughout 2020, with shares collapsing by nearly 70% on a year-to-date basis.
While this trend certainly has been painful for many investors, I believe that the end is in sight. Specifically, I believe that within the next few months, natural gas will reverse its decline and that we will see the price of gas rise, benefiting BOIL holders. Ultimately, however, I must caution investors trading BOIL to only give strategic allocation to the ETF due to very heavy roll yield losses associated with the product.
Natural Gas Markets
To start this piece off, let’s take an objective technical look at the past few months of price action in natural gas futures.
From a relative perspective, natural gas has actually been somewhat boring or even frustrating to trade since April. What I mean by this is that the broad-based selling which was seen throughout March essentially ended during April, and since then, the market has generally gone sideways.
When I see the market trade sideways for prolonged periods of time, it is my view that the market is transitioning from one fundamental regime to another. What I mean by this is that it is my view that fundamentals rarely switch from bearish into bullish on a dime and it takes several months of trading back and forth (or going sideways) until we see price start trending in another direction.
At present, I believe the technical picture has shifted back into neutral with the bullish momentum seen at the start of the month fading somewhat. However, I believe ultimately the trend is poised to reverse and that in the coming months, we will see gas break out into new highs and reverse much of the decline of 2020.
The reason for my optimism is based on an objective reading of the fundamental data. Specifically, I believe that production is correcting downwards and this downwards correction in production will be met with an increase in demand. Classic economics shows that when demand increases relative to supply, prices rise. In this light, it’s a great time to buy gas.
This view is mimicked with the EIA to a good degree. The EIA is an objective government administration that assembles and monitors data pertaining to energy in the United States. It has no market view, so its views are generally considered to be as objective as possible.
In its latest Short-Term Energy Outlook, the EIA has the following chart.
What this chart shows is that the EIA is currently calling for production to substantially decline through the next few quarters. Without knowing the demand picture, we can’t make a comprehensive statement regarding the supply and demand balance. For example, as seen in the following chart, the EIA is expecting gas demand to decline as well during this time period.
If you do the math, however, throughout 2020 and 2021, larger declines are expected to hit production than are expectations for demand. Put simply, the EIA’s objective analysis is fairly bullish natural gas in that even though supply and demand are both expected to fall, we should still see stronger demand than supply.
Seen from the total balance perspective, the EIA is calling for year-over-year decline in basically every quarter from here through 2021.
When studying natural gas, it is highly important to understand that an outright build or draw doesn’t really say much about inventories. That is, gas inventories reliably increase during the summer and reliably draw during the winter. This pattern is recurring and can clearly be seen in the seasonal chart of inventories.
What this means is that the only way we can make a statement regarding the strength or weakness of inventories is to strip out seasonality. That is, since inventories typically build during the summer and draw during the winter, we need to compare the pace of builds or draws to what is seasonally normal to get an idea as per the strength or weakness in fundamentals. It is this seasonally-adjusted number which ultimately drives prices, as seen in the following chart which strips out seasonality by taking a year-over-year change in gas inventories.
It is in this light of seasonal numbers that we must revisit the prior balances chart provided by the EIA. The EIA is expecting above-normal draws and below-normal builds throughout 2021 in almost every quarter between now and then. What this means is that on seasonal basis, the objective analysis of the EIA is quite bullish. Indeed, in its latest STEO, the EIA is calling for the price of gas to rally by a whopping 91% between now and next summer and by over 100% between now and the end of 2021.
I agree with the EIA’s analysis and it matches my own fundamental analysis. I believe that supply is in collapse.
And I believe that demand is set to be very strong this summer due to climbing gas demand and NOAA’s weather models.
Ultimately, I am bullish natural gas due to these reasons and I believe that the EIA’s analysis gives a very similar and objective confirmation point. My personal opinion is that the EIA’s price forecast is a little too bullish in that my study of history indicates that a 50% rally is more likely than seeing gas double over the next year, but regardless, for BOIL the fundamentals are almost overwhelmingly bullish at this point.
Despite the fact that the fundamentals are quite bullish, we must temper this analysis somewhat due to the harsh realities at work in the BOIL ETF. This harsh reality is, of course, that of roll yield. BOIL is an ETF giving a 2x leveraged return of the main natural gas index provided by Bloomberg. This index is pretty straightforward in that it gives exposure to the front gas contract and then shifts this exposure into the second gas contract some time before expiry. Here’s the problem with this approach in a single chart.
In this chart, I’ve taken the average difference between the spot price of natural gas and the front four futures contracts and grouped the data by trading day in a month. What this data shows is pretty clear: the front contract in natural gas futures converges towards the spot price to the greatest degree of all of the contracts and, on average, the front contract is above the physical commodity.
There’s a lot of data contained in the prior chart and paragraph, so I’d encourage you to read over it carefully if you’re unfamiliar with the problem of roll yield. To cut straight to the chase, on average, the front contract contracts by about 1.5% per month or 14-18% per year. In other words, in a given year, if you were just holding the front futures contract rather than the spot commodity, you would underperform the changes in natural gas by an average of about 14-18% per year. BOIL gives a 2x leveraged return of the front contract, so this number is multiplied by two.
And that’s the huge issue to consider when you trade BOIL and why I can only suggest strategic exposure to the product. Put simply, futures convergence is taking a huge toll on earnings and investors need to mitigate and manage exposure accordingly. So, while I believe that gas is fundamentally set to rally, I believe investors should only hold BOIL using pre-defined entries and exits. For a simple strategy, consider only buying when natural gas prices hits a new 1-month high because this will indicate that the trend may be shifting.
Gas fundamentals are decisively turning with production declines to offset losses in demand through 2021. The EIA is calling for gas prices to rally by over 100% between now and the end of 2021. BOIL is heavily exposed to roll yield which means that investors should manage their holdings accordingly.
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.