With Oil on the Rebound, Natural Gas Could Follow

Above is a graph of various commodity ETFs. The main ticker is UNG (United States Natural Gas Fund), an ETF which tracks prices of natural gas delivered at Henry Hub. OIL is the iPath Oil ETN. JJA is the iPath Agricultural Commodities ETN. JJM is the iPath Industrial Metals ETN. And, JJP is the iPath Precious Metals ETN.

The chart displays the year-to-date performance of these various commodity indexes and it’s plainly obvious that one stands out among the others. Generally speaking, non-energy commodities have been on an upward trend since the beginning of the year and in fact would have provided mid-to-high teens returns just in the last few months! Even oil, though down precipitously in the first two months of the year, has rebounded swiftly to near break even year-to-date. Only one commodity seems to have lagged behind the rest - natural gas.

Natural gas prices have declined nearly 40% since the beginning of the year and have not at all responded to the recent bullishness in the markets. I’ve written before about the value of having oil exposure in your portfolio, but the same could be said of energy exposure in general. These types of commodities act as a hedge against inflation, a direct hedge against increasing energy costs taking a toll out of the businesses you’ve invested in, and prices are supported to some degree by near universal demand and constrained supply.

Natural gas, however, is fundamentally different from oil and this fundamental difference could explain its recent lag as well as give us insight on its potential to rebound swiftly and vigorously.

1. Oil is a global market while natural gas is a domestic market. Oil can be easily transported on tankers and through pipelines whereas the transport of natural gas is significantly more difficult. As a result, demand for natural gas in the United States more strictly follows US industrial/residential demand.
2. Natural gas is typically considered a backup to crude oil. Power plants typically have back up turbines powered on natural gas. In another example, the production of ethane for industrial uses is often determined via the price/value tradeoff of using natural gas or petroleum as a feedstock.
3. Due to natural gas’ secondary nature as a feedstock/fuel, demand is considered seasonal. Temperature extremes (hot or cold) put extra stress on the energy grid and cause providers to flock to natural gas as a way to control costs in the face of rising demand for petroleum and to quickly scale output to meet demand. Similarly, increasing industrial utilization eventually drives producers to choose natural gas as a feedstock for their processes.

As the summer months and potential supply shocks due to hurricane season approach, the time is ripe for natural gas to begin catching up. In 2006, the Department of Energy published a statistical study of natural gas and oil prices between 1989 and 2005, its findings were consistent with what we expect from the above mentioned characteristics of natural gas. As a secondary substitute to petroleum, long term natural gas and oil prices move with significant correlation to one another. Natural gas prices, however, tend to lag large changes in oil prices and their correlation is muted when oil price changes are transitory as opposed to permanent.

If you’re thinking about making a play at natural gas, the key question to ask is whether or not the current rebound in oil is here to stay? More fundamentally, this is a question of how significant and how rapid the rebound in industrial production in the United States will be. I won’t pretend to be a master of economic and business indicators or to have a crystal ball, but what I do know is that having the benefit of watching oil and other commodities, betting on natural gas is not a difficult leap at all.

Full disclosure: Author has no direct positions in any of the funds and commodities mentioned in this post. Author is long shares of LINE, an oil and gas MLP, and VLO, an oil refiner.

Comments

[tc1:]

Thank you for a very informative article. I have some big holdings in LINE and some other firms in the natural gas & oil industry; i've been wondering about getting further invested in natural gas via UNG and your article gives me some valuable information here.

Jun 03 10:39 AM

[buyforeclos...:]

Rough day...VLO downgraded and UNG getting crushed


However, If oil heads back up ung will too ...problem with NG is that we expect mild hurricane season...currently in injection season with NG amd we are already at historical highs as far as reserves go..that is why it is no longer in sync with oil prices. If you look at a 25 year chart you will see that NG prices ( I know production has been cut and will help in time) really are not THAT low. They decades in the 2's

I do expect NG to be in the 5's before end of year. Currently at high 3's
If dollar is stable anytime soon expect oil to be back at 58 before end of summer

Jun 03 10:57 AM

[kewlhand:]

Your logic is impecable, but oddly UNG is down 8% today as I speak!! Any guesses as to why?

Jun 03 11:26 AM

[Mad Hedge F...:]

that's what I think. Every evening, after the cleaning staff has swept up the discarded trade tickets from the floor, the networks have swapped relentlessly opinionated commentators for game shows, and all but the most ambitious traders have decamped for the bars across the street, I sit down and go over my portfolio, asking myself a few key questions. Have I gone completely insane? What have I missed? Are these the positions of someone who has gone completely barking Mad (oops)? Just as I was going through this exercise last night, a long time friend from the energy industry, who used to put me up in his Dallas mansion when I was wildcatting for natural gas in the Barnet Shale a decade ago, called me up and told me I was out of my tree putting people into NG at $3.60. Huge discoveries, such as the Hainesville shale in Alabama, have made available enough NG to last the US another 50 years. The new generation of fracting technology, while great for taping into marginal, low grade fields, is much more difficult to turn off when prices are low without causing permanent damage. And then there is the looming threat of large scale LNG imports from abroad. The big gas companies will be forced to dump whatever they have on the market at any price, possibly taking prices this summer down to $2, or even $1. This, after all is the mother of all overshoot contracts. Of course, one could argue that these risks are what already took it down to $3.20, and that industry demand will happily soak up the excess supply. Did I mention that the hurricane season started yesterday? Only Mr. Market knows for sure, and he ain’t talking. In the past month, my calls have enabled traders to catch a 50% move in NG, followed by a 20% move (www.madhedgefundtrader... ). No one will think less of you if you want to cash out here at $4.30 and stay on the sidelines until a more definitive bottom is put in. As they love to tell you in flight school, there are old pilots, and there are bold pilots, but there are no old, bold pilots.

Jun 03 11:27 AM

[Heaven, Hel...:]

Another salient point not included in the thesis is that natural gas is "cleaner" than oil, i.e., results in lower greenhouse gas emissions. But on the flipside, point #1 is becoming less of a compelling factor with the coming online of seven large LNG projects this year and the status of the US as "dumping ground of choice" for once stranded, now transportable gas reserves.

Jun 03 11:31 AM

[H. T. Love:]

Quoth the author

"As the summer months and potential supply shocks due to hurricane season approach, the time is ripe for natural gas to begin catching up"

CSU just predicted a milder hurricane season for this year. So odds are we'll have less impetus from that.

Additionally, the traditional ratios twixt oil/gas seems to have broken down last year.

With the market in general as volatile as it is, I think timing would be an important consideration here. You may need your cash in a mattress after the banks finish their secondary offerings and the market is allowed to recede to its natural level.

I've been looking to reenter UNG, after taking some profits recently and have been looking at things as closely as I can. A couple of days ago I realized that a blog was a better way to keep track of things I investigate and discover, so I started one for UNG. It is *not* intended for public consumption. Not a lot that would be useful to others there yet.

I'm brand new at this investing/trading stuff, so if you visit it, keep that in mind. I haven't done today's update yet, but UNG is doing as I expected today. Also, be kind as you can tell by my moniker that I'm very sensitive (NOT!). >:-)

seekingalpha.com/accou...

Since BO seems to favor liquefied coal over NG (I presume because of the political backing received from that constituency during the campaign) I expect no surge in NG use and it should be heading back down to the sub $13 range over the near term, *unless* it just gets dragged higher by oil - unlikely in my opinion. If I read my charts right (remember I'm n00b), resistance resides at about $15.50.

There are definitely some trends in place that will support it long-term, but the biggest ones are still developing slowly. Only a harsh winter and the continuing shutdown of pumping stations will help it even hold at these levels in the intermediate term.

My humble opinion,
HardToLove

Jun 03 11:48 AM

[optionsgirl:]

I am long UNG and Dec call options in the NG futures. I also sold calls against both positions.

No question nat gas can only go up long term.The gyrations can kill you in the meantime. Hedging just seemed prudent, even at these low levels.

Jun 03 11:48 AM

[H. T. Love:]

On Jun 03 11:26 AM kewlhand wrote:

> Your logic is impecable, but oddly UNG is down 8% today as I speak!!
> Any guesses as to why?

Because Henry Hub futures dropped about $0.10 yesterday alone.

HardToLove

Jun 03 11:50 AM

[optionsgirl:]

Short term, Obama's preferences have nothing to do with utilities choice to use nat gas v coal. They will use whatever is cheapest.


On Jun 03 11:48 AM HardToLove wrote:

> Quoth the author
>
> "As the summer months and potential supply shocks due to hurricane
> season approach, the time is ripe for natural gas to begin catching
> up"
>
> CSU just predicted a milder hurricane season for this year. So odds
> are we'll have less impetus from that.
>
> Additionally, the traditional ratios twixt oil/gas seems to have
> broken down last year.
>
> With the market in general as volatile as it is, I think timing would
> be an important consideration here. You may need your cash in a mattress
> after the banks finish their secondary offerings and the market is
> allowed to recede to its natural level.
>
> I've been looking to reenter UNG, after taking some profits recently
> and have been looking at things as closely as I can. A couple of
> days ago I realized that a blog was a better way to keep track of
> things I investigate and discover, so I started one for UNG. It is
> *not* intended for public consumption. Not a lot that would be useful
> to others there yet.
>
> I'm brand new at this investing/trading stuff, so if you visit it,
> keep that in mind. I haven't done today's update yet, but UNG is
> doing as I expected today. Also, be kind as you can tell by my moniker
> that I'm very sensitive (NOT!). >:-)
>
> seekingalpha.com/accou...
>
> Since BO seems to favor liquefied coal over NG (I presume because
> of the political backing received from that constituency during the
> campaign) I expect no surge in NG use and it should be heading back
> down to the sub $13 range over the near term, *unless* it just gets
> dragged higher by oil - unlikely in my opinion. If I read my charts
> right (remember I'm n00b), resistance resides at about $15.50.<br/>
>
> There are definitely some trends in place that will support it long-term,
> but the biggest ones are still developing slowly. Only a harsh winter
> and the continuing shutdown of pumping stations will help it even
> hold at these levels in the intermediate term.
>
> My humble opinion,
> HardToLove

Jun 03 11:50 AM

[optionsgirl:]

p.s. for those of you who take stock in the National Hurricane Center predictions- they are great when the storm is forming. (That is sometimes the best time to trade nat gas and the orange juice market, too- when the storm is coming.) Those reports are not reliable to predict a whole season in advance.


On Jun 03 11:48 AM optionsgirl wrote:

> I am long UNG and Dec call options in the NG futures. I also sold
> calls against both positions.
>
> No question nat gas can only go up long term.The gyrations can kill
> you in the meantime. Hedging just seemed prudent, even at these low
> levels.
>

Jun 03 11:55 AM

[H. T. Love:]

On Jun 03 11:27 AM Mad Hedge Fund Trader wrote:

> <snip>
> damage. And then there is the looming threat of large scale LNG imports
> from abroad. <snip>

I've been thinking about this issue a lot, as I believe there is a very strong future for NG long-term. But I'm too n00b to have confidence in my assessments. Can you help out?

1. We continue to trash the dollar, the world responds as expected and the $ becomes more valuable as a firewood substitue than as a medium of international exchange.

2. Foriegn co's that planned to sell to us see no value in selling for dollars at the prices in dollars they can get (our homegroan supply would be cheaper and dominate), considering all costs, and they sell to stronger currency countries instead.

3. Our ample homegrown supply, which takes profit in dollars and sells in dollars, can see profits as demand does rise and we see prices rise as well reopenings lag demand.

I may be way off base, but the worst that happens if I ask is I look foolish.

Thanks for any thoughts,
HardToLove

Jun 03 12:01 PM

[H. T. Love:]

On Jun 03 11:50 AM optionsgirl wrote:

> Short term, Obama's preferences have nothing to do with utilities
> choice to use nat gas v coal. They will use whatever is cheapest.
>

In a real-world, yes. But we don't live in that anymore. The tax system and subsidies imbedded in the Pelosi congress bills will have an effect on the business case. There are other state-mandated actions that also affect the utilities actions.

HardToLove

Jun 03 12:08 PM

[tunaman4u2:]

Ouch, UNG & VLO today... thats a bad day... I owned both VLO & UNG recently.... UNG has been insane with 10% daily swings of panic in either direction. Hold onto your hat!

Jun 03 01:06 PM

[Sober Realist:]

"If you’re thinking about making a play at natural gas, the key question to ask is whether or not the current rebound in oil is here to stay?"

The EIA publishes its weekly stock numbers on oil and other petroleum products each Wednesday. www.eia.doe.gov/oil_ga...

or you can look at the raw numbers here:

tonto.eia.doe.gov/oog/...
(Click on the Data 1 tag)

This week analysts thought stocks would drop by some 2 million barrels. Instead they increased by 2.866 million.

May 29, 2009 365.977 million bbls
May 22, 2009 363.111

That’s a 5 million bbls error which is huge. But it doesn’t begin to capture just how insane the oil market really is. This is the crude oil stock number from last year at this time.

May 30, 2008 306.757 million

We are currently carrying 59.22 million bbl more this year than last year. This is in large part due to the fact that the economy is doing so much worse this year. But that is rather the point. Supply is through the roof. The economy sucks, and the near oil crude future has doubled from its low of $30.28 which it hit on December 23, 2008 at the bottom of its collapse from the previous speculative binge, --or if you prefer the 2009 low, $34.03 on February 12, 2009.

tonto.eia.doe.gov/dnav...

What this screams is manipulation. It is a subsidy for oil producers, a windfall for investment banks, and a hidden tax on already cash strapped American consumers.

Jun 03 04:00 PM

[harammph:]

OG: keep posting: I use Joe Bastardi myself, Accuweather.com

Jun 04 01:16 AM

[tunaman4u2:]

124 BCF build! WAY more than expected UNG crushed... Bought some on the dips... this is NOT a hold investment... Nat Gas is CRAZY right now...VERY cheap compared to oil

Jun 04 10:48 AM

[felixd:]

Would also add that number of rigs exploring for and drilling for new Natgas has dropped some 50% over last year. Eventaully the declining rig count is going to start showing up in lower supply. When that happens natgas should move quickly higher as it takes a lot longer to bring supply back on, than it is to shut it down. That means a long rally in natgas. Only question is when will it start? Wish I knew that.

Jun 04 02:39 PM

[tunaman4u2:]

You're telling me bro! I'd love a explanation why Oil does not follow any supply data whatsoever & at the same time Nat Gas is the whipping boy... hell ALL the other commodities have seemed to zoom up for "future recovery" but nat gas...
If UNG didn't have to roll contracts like it does I would LOVE to buy & hold but the front mo contract could stay the same price for the next 8 months & nat gas would be 5.50 & youd be DOWN!


On Jun 04 02:39 PM felixd wrote:

> Would also add that number of rigs exploring for and drilling for
> new Natgas has dropped some 50% over last year. Eventaully the declining
> rig count is going to start showing up in lower supply. When that
> happens natgas should move quickly higher as it takes a lot longer
> to bring supply back on, than it is to shut it down. That means
> a long rally in natgas. Only question is when will it start? Wish
> I knew that.

Jun 04 02:45 PM

[Shale Gas:]

Penn Virginia just announced a successful well in the Haynesville Shale, which is not seeing a cutback in drilling, as operators are moving rigs from more mature areas to higher growth and lower cost shales. However, I agree that as the overall rig count drops in North America, we should see a drop in supply.

Jun 05 11:14 AM

[buyforeclos...:]

sober..u nailed it. Manipulation by GS and others...GS clients lost a ton on their $50 oil call and now they are trying to get them long and make that money back plus some... I hate GS and all those crooked analyst . They looks for large short floats and then upgrade those stocks after their clients get in...SEC is clueless ..this is so obvious.....Continental Airlines upgrade recently? WHO is upgrading ANY carrier with such large debt loads ( secondaries waiting to happen) and travel down big time.... ..hell, they ugraded whole foods.... like Im ( or most people ) am going to buy a head of lettuce for 5 bucks ...unreal. I was short on that one too! But made money before the upgrade ..not nearly as much as I should have. Need I say more?

Jun 05 03:03 PM