As you can see in the following chart, the United States Natural Gas Fund (UNG) has had a bit of a hot streak with prices rapidly reversing much of the losses seen this year.
It is my view that UNG has gone too far in too short of an order and is due to correction. However, I also view that in the long run (over the next few months), UNG is almost certainly headed higher due to strong natural gas fundamentals.
Natural Gas Markets
To start this piece off, let’s attempt to make sense of the recent rally, starting with a high level view of the fundamental balance.
Put simply, natural gas is rallying strongly while inventories are pushing into new multi-year highs for this time of the season. In other words, from a surface perspective, gas prices appear to be doing something contrary to what typical fundamental data would suggest. However, when we look at the changes in the above chart, we can see that despite outright inventories hitting new highs, the rate of change is looking to be quite bullish.
What this chart shows is that even though gas inventories are building (as should be expected this time of the year), the rate of change has been either at or below the 5-year average for some time now. When compared to the earlier part of this year (a time when inventories were ballooning upwards), this is a quite bullish adjustment.
However, can this simple adjustment towards the 5-year average explain a rally in natural gas of over 50% within the space of a month? No, I believe there was another key factor at work beneath the surface which has driven this change: short covering.
What this chart shows is the total open interest of money managers in Henry Hub futures. What you can see is that starting around the May timeframe natural gas traders started adding to long positions at such a pace that they outnumbered shorts. Gas traders continued adding to long positions and essentially squeezed the short traders such that short length was reduced over the coming weeks. This short squeeze resulted in a reduction of short open interest to the lowest levels since early 2019.
Put simply, I believe a good degree of the recent rally was due to a very large short-covering which occurred amongst professional traders. However, this doesn’t mean that there are not valid reasons supporting the rally in natural gas. For example, the key fundamental theme to zero in on here is the story at work in gas production. Put simply, it is in strong decline.
In and of itself, production in decline isn’t bullish or bearish – we must also factor in demand. And demand is dropping as well.
However, if you do the math, you can see that the rate of change is very favorable to the bulls: that is gas production is declining faster than gas demand is declining. This is precisely why we have started to see gas inventories slow the pace of builds to be at, or even under the 5-year average.
This concept is really important to grasp: inventories are slowly becoming more bullish even with suppressed demand. In other words, if we see even a moderate uptick in demand, we will see a strong draw in natural gas stocks – assuming of course that production remains suppressed.
I believe this is the key message which gas traders are focusing on at this point. The key reason here is that if you can call changes in inventories, you have a very strong probability of successfully calling the changes in the prices of natural gas.
In the short run, I believe that gas prices have gone too far and too fast. A 50% rally in the space of 1 month is more of a short-covering phenomenon than an actual fundamental adjustment in my book. For this reason, I’m actually somewhat bearish natural gas over the next few weeks. However, when it comes to broad fundamental adjustments, I still believe that we are in step to see a sustained upwards adjustment to the price of natural gas over the next few quarters as supply adjusts downwards at a faster pace than demand.
Unless we are purely trading natural gas futures, then we must pay as much attention to the methodology of any specific gas ETP as the market itself. In fact, I would go so far as to say that methodology can be one of the most important factors when choosing a gas ETP and in the case of UNG it is perhaps one of the best explainers of the long-run returns of this ETF.
The reason why I say this is that UNG is one of the most straightforward natural gas ETPs: it gives exposure to the front natural gas futures contract and then about two weeks before expiry it shifts exposure into the second month.
In the gas ETP space, this methodology is actually fairly rare – in my research of the various natural gas products, most are cognizant of a very important elephant in the room: roll yield. UNG seems to have purposely ignored this facet and instead focused on the most direct investment in gas futures, which is the front-month contract.
The benefit of such an approach is this: it’s highly correlated with the outright changes in the price of gas over the short term and it’s fairly volatile. So if you like volatility and lots of short-term action, UNG is a good unleveraged product.
But here’s the major problem with UNG’s approach:
This chart shows the average difference between the first and second month futures contracts and the spot price of natural gas grouped by number of days into a trading month. This chart shows a very clear and consistent relationship which is that on average, natural gas futures are priced above the spot level and on average this difference narrows during the month, with the front contract carrying most of the convergence.
This is the problem with UNG. And it’s a very big problem. This data shows that on average, UNG is seeing convergence to the tune of 1.3% per month (or around 16% per year). This data means that on average, when you are holding UNG, you will see losses in the territory of 16% per year if the price of natural gas goes nowhere.
This should not be overlooked because this is a very real issue for UNG. Over the period of several years, you can see that this convergence will essentially erode the value of the ETF, requiring massive movements in the price of gas to simply be breakeven.
This is why I can only be moderately bullish UNG and only for specific time periods. Since UNG has chosen to hold exposure in the front contract and since this contract converges to such a strong degree, it is facing serious headwinds to profitability. For this reason, I suggest that investors be very strategic about their holdings and have clearly defined entry and exit rules to manage the time in this instrument. For example, as a simple strategy, I would suggest only holding UNG while it is above something like 1-month average of price as a simple technical strategy for strategically capturing the fundamental theme at work in the commodity.
Natural gas prices have gone too far and too fast, largely driven by a short-covering rally. Despite the overshot to the upside, gas fundamentals remain bullish and investors should look to buy pullbacks. Roll yield remains a sizable hurdle which necessitates a strategic method of exposure to UNG.
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.