Over the past few weeks, the ProShares UltraShort Bloomberg Natural Gas (KOLD) has taken a very strong hit, as gas has rallied substantially.
My current market view is that while KOLD is likely oversold in the short run, in the medium to longer term, KOLD is probably headed lower.
Natural Gas Markets
Let’s start this piece off by examining the past few weeks of trading action in natural gas.
Put simply, this has been a very strong rally in the price of gas. In fact, over the past month, we have seen the price of natural gas increase by over 50%. From a historical perspective, this is the largest surge in momentum seen since the winter of 2018 – a time period in which natural gas rose due to tight fundamentals.
From a technical perspective, I am concerned that this trend is overextended. Specifically, I believe that momentum has been too strong to the upside, and that over the coming weeks, we will see a correction. One of the data points I’m looking at to make this assessment is the MACD indicator in the chart above. This chart measures the differential between two different moving averages and gives a general gauge as per momentum. As you can see, we are currently poised to see positive momentum switch into negative momentum following a very large rally. For historical perspective here, the last time we saw momentum this strong was during the previously mentioned rally of 2018, and the next few weeks saw a sizable correction of the trend.
So, from a technical perspective, I am short-term bearish natural gas. However, I do believe that the fundamental data is still giving a very strong long-term buy signal. We’ll discuss the fundamental data points in the next paragraphs, but from a strategy standpoint, this short-term technical bearishness is setting traders up for a strong buy entry into gas over the next few weeks.
The largest change at work in the natural gas balance is production. Put simply, we are in the midst of one of the largest drops ever witnessed.
The reason for this incredible drop in production is quite simple: prices have been falling for too long and they have gone too far.
At the end of the day, if you’re not making money from producing natural gas, then you likely will slow or stop natural gas production. This simple message is fully understood by producers, as the rig count has remained low.
As you can see from a historical perspective, it takes several months (or even quarters) of rising prices before drilling and production recover.
And from a regional standpoint, production losses are broad-based, which indicates that we need sustained price rallies to incentivize each of the major regions once again to see a recovery in output.
We’ve somewhat belabored the point, but it’s a very important data piece to grasp: production is in collapse, and we are almost certainly going to see low levels of production until we see a consistent recovery in the price of natural gas. In other words, a large 1-month rally in the price of gas won’t save the market – we need several quarters of price either generally holding these levels or continuing higher.
As per forward guidance, we can turn to the EIA’s latest Short-Term Energy Outlook for a clear market view.
Put simply, the EIA sees this current decline in production carrying forward into 2021. And compared to demand, this is quite bullish in that while the weakness in demand is forecast to carry forward, it is to a lesser extent than the losses seen in production.
And the reason why this all matters for gas traders is this: when supply is unable to keep up with demand, gas prices rise. It’s that simple – at the end of the day, supply and demand is what impacts price, and traders need to monitor broad changes in these variables to understand where gas prices are likely headed.
Given that supply is collapsing at a faster pace than demand, the market is quite bullish at this point from a fundamental standpoint. However, the recent strength in natural gas tells me that investors should consider waiting for a few weeks prior to buying into the commodity. Ultimately, this view is bearish KOLD, since it is short natural gas.
Prior to leaving this analysis, we must make a few comments about KOLD’s methodology and its implication. Gas ETPs are very interesting creatures in that while investors can trade the note or fund and believe they are getting the return of natural gas, specific methodologies can result in very different outcomes for investors.
In the gas ETP space, KOLD has a somewhat different approach than other notes and products. Specifically, KOLD is inversing the Bloomberg Natural Gas Subindex. This index is different from other more popular alternatives (like that followed by products like the United States Natural Gas ETF (UNG)) in that it is trading the second-month futures contract rather than the front-month contract. For example, here is its current exposure.
From a high level, KOLD is fairly straightforward: it is short natural gas futures on a twice-leveraged basis. The nuance for gas investors here is that when you trade gas futures, you’re actually subject to two different sources of return: the outright change in the price of natural gas, as well as the amount of futures convergence (or roll yield) priced into the curve.
Since KOLD is holding exposure fairly close to the front of the curve (second month exposure), it is exposed to a degree of futures convergence on most days. What I mean by this is that on average (about 85% of the time), natural gas futures are in contango, which means that they are priced above the spot level of gas. Convergence is simply the fact that futures contracts move towards the spot price of the commodity through time, which means that if a futures contract is above the spot price, it will decline in relation to the spot.
This key feature of natural gas futures curves means that KOLD is actually rewarding long traders in the ETF through time. Since it is short futures which are in contango, it is collecting roll yield as futures converge towards spot. It is important to note that these gains from roll yield will not outpace outright changes in the price of natural gas, but they can ease losses or add to gains.
It is also important to note that since KOLD is holding close (but not fully prompt) exposure, this gain seen from futures convergence is not as amplified as a short position on, say, UNG would be. For example, as of my latest calculations, the front-month contract narrows by about 1.3% per month, while the second-month contract will only narrow by a third to a half of a percentage point per month. This may seem slight, but the differences do add up. For example, if natural gas were to go nowhere in a typical year, you could see KOLD’s share price increase by 12% or so, simply because it’s double short roll yield on the second-month futures contract.
Given the fact that natural gas futures are broadly in contango, and given the fact that futures converge, KOLD is benefiting from roll yield. However, I remain bearish the ETF because I believe that gas is set to continue rallying (after a moderate pullback). For this reason, I suggest that investors exit their KOLD holdings at this point.
Natural gas prices have rallied too far and too fast, which suggests a sell-off in the short run. Gas production is declining at a faster pace than demand, which is bullish the commodity. Roll yield remains a benefit to traders of KOLD. However, gains in gas are likely going to outpace this feature.
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.