Two Natural Gas ETFs to Track the Rise in Gas Prices

The following is from Kelly Letter Note 55, sent to subscribers first thing in the morning on Sunday, August 16.

We've been watching US Natural Gas (UNG) as a possible buy to track what we believe will be a gradual increase in the price of natural gas when the economy gets back on an earnest growth path.

Several subscribers have written to ask if there isn't a better way to buy into the thesis. UNG, they've read and noticed, has not tracked the price of gas well. One suggested alternative is First Trust ISE-Revere Natural Gas (FCG). Instead of tracking the price of gas itself, FCG tracks an index of companies that earn "a substantial portion of their revenue from the exploration and production of natural gas." For details on the ISE-Revere Natural Gas index and a list of its component stocks, click here.

We explored in Note 45 sent July 12 whether UNG was better than three natural gas producing stocks, Chesapeake Energy (CHK), Cheniere Energy (LNG), and Southwestern Energy (SWN) in two time periods: December 2007 to end of June 2008, and end of June 2008 to July 10, 2009. The result:

It looks to me that UNG packs all the punch of the stocks, without any of the company risk. We don't need to worry about earnings shenanigans, bad management decisions, bankruptcy, or any of the other common pitfalls of stocks. LNG obviously has problems beyond the price of natural gas, so we can strike it from the list. Against CHK and SWN, UNG performed better in the rising period and has dropped farther in the falling period.

That made UNG look like the best coiled spring in the sector. If we introduce now not just three natural gas stocks, but the ISE-Revere index of them, will the results change? Given more data available now, we'll extend the second time frame to last Friday.

Rising period from end of December 2007 to end of June 2008:

FCG rose 42% from $22.13 to $31.39

UNG rose 74% from $36.25 to $62.97

Falling period from end of June 2008 to August 14, 2009:

FCG fell 53% from $31.39 to $14.71

UNG fell 80% from $62.97 to $12.49

Pull up a two-year chart comparing the two ETFs and you'll see that they both traced out roughly similar patterns except for an initial price drop in UNG in January 2007 and then a departure in early December 2008. Last December saw FCG start working its way higher as UNG kept going lower. That's led to an extreme performance divergence since then, with FCG up 13% but UNG down 54%.

Some have called that a tracking error, as if the two ETFs are supposed to follow the same underlying benchmark. They're not. FCG follows an index of natural gas stocks while UNG follows the price of natural gas itself. Has UNG failed to track the price of natural gas?

Here are the closing natural gas prices per million British Thermal Units (mmBtu) at the Henry Hub on the first trading day of each month this year:

$5.41 January

$4.48 February

$4.36 March

$3.56 April

$3.30 May

$3.86 June

$3.63 July

$3.43 August

During that time, the price of natural gas declined 37%, and UNG declined 43%. That's not perfect tracking, true, but it got it right in spirit. That's all we're trying to do here. When that price history at the Henry Hub goes the other way, UNG will ride it upward. It won't be precise, but it will go the way the price is going and may well leave the natural gas stock index in the dust, as it did in the seven months ended in June 2008.

We're still holding out for $12 on UNG, by the way, and it's slowly getting there. Last week, it declined 4.9% to $12.49 on news that America's already overflowing natural gas inventory grew even more due to the weak economy. Low demand, snappy production at both conventional and unconventional sources such as shale, and mild weather have all conspired to send inventories to the moon. The latest build puts America's gas in storage at 3.152 trillion cubic feet, about 20% above its five-year average.

Some analysts are worried that we'll suffer a complete price collapse before recovery, an event that could see UNG fall well below $10. If storage space runs out -- as it's in danger of doing in many places, such as East Texas -- prices will have to sink to force shut-ins and completion deferrals. That kind of talk is common at bottoms, though, so let's first keep an eye on UNG $12 and then think harder if/when we're below it.

Comments

[basehitz:]

I was surprised the tracking error of UNG to NG wasn’t much greater for that 6-month period. It gets a lot trickier now.

1) Contango had been 3-5% from April-July, but has ballooned over past 3 weeks to 11% currently. We are currently in the middle of the UNG roll period. If it stays this high, that’s an ugly negative roll yield to take each month.

2) Next we have the UNG fund currently not issuing new shares despite recent approval. Instead, managers are currently examining investment alternatives, such as swaps and soon-to-be-regulated futures contracts.

3) There’s the ongoing CFTC debate over new regulation, likely in the form of position limits.

4) NG storage at 3.152T vs estimated storage capacity of 3.789T (per EIA). If injection rate avg of past 3 weeks continues linearly, it is expected to exceed storage limit in mid Oct, which is not the end of typical injection period.

5) Energy prices in general are influenced by the general market, which looks tired.

6) Finally we have a trio of storms heading across the Atlantic.

Regarding playing FCG instead of UNG. . . Charting OIH vs FCG over 1 year period. is a good correlation. OIH holds a large component of international and deepwater oil drilling, which is attractive and my preference.

Long term, it seems beyond question there will be stronger NG prices next year given the depletion rate characteristics for active shale fields coupled with reduced drilling. Short term, is a tricky call. You know traders will be jockeying for position with these storms Monday.

Aug 16 12:06 PM

[Tgarfield:]

UNG should track NG because it is a ETF. It does not NG because they can not issue more shares of UNG. It is currently overvalued by 11.8%. Attempting to compare UNG to anything else is a gamble at best. IF NG goes up 5% the other funds will rise. UNG might still fall. NG could go up 10% and UNG might go no where. There is nothing to make it go up. Most likely NG will rise into fall but will do so with major contango which will cause the NAV of UNG to fall more. UNG will eventually correct to NAV. As the assets of UNG get diminished on ever rollover, they will be able to take another position in NG, and add shares. This is of course done through naked shorting like any other ETF. UNG is a troubling ETF which currently tracks nothing, especially it's NAV. NAV of UNG is found on the web site.

Aug 16 02:57 PM

[dieuwer:]

The tracking problem could be circumvented if UNG would store NG and issue shares against its holdings.

Aug 16 03:22 PM

[Mad Hedge F...:]

uiioo. I love it. The fat lady is singing on natural gas. Not only did we plunge to a multi month low of $3.23/MCF, the crude/gas ratio blew out to yet another new high of an amazing 21 times, wiping out yet another generation of quant players. How many standard deviations is this? Their computers must be melting from the models that are exploding. Didn’t anyone tell them these are just tools, and not gospel? The big providers have just not been able to shut down production fast enough. It looks like Chesapeake Energy’s Aubrey McClendon (CHK) is going to have to sell more of his wine collection and artwork (click here for their website). I have been overwhelmingly negative on NG since early June, (click here for report) , suffering an Internet full of abuse in the process. But you want to buy the final washout, because market conditions are bound to improve this winter. Let’s see if you can get a $2 handle, which traders have not visited this century.

Aug 18 01:10 AM

[Buck East:]

"when the economy gets back on an earnest growth path," and what what will be the forces that create that phenomenon, pray tell? Fed direct deposits into people bank accounts? Cash-for-clunkers, and cash-for-chickens, and cash-for-gas-wells? Laughable. Mad Hedge, I have been with you all along, definitely $2 handle, $2.75 is pretty likely. Where will prices go when storgage is MAXED OUT? Obtw, Baker Hughes NG rig count up for the past five months.

Aug 18 06:09 PM

[Buck East:]

There has not been much of the reduced drilling, Shale companies are still drilling shale wells as for most it is their only source of cash and they are staring down the barrel of debt. Baker NG rig count up for the past 5 months--what do you think of that?


On Aug 16 12:06 PM basehitz wrote:

> I was surprised the tracking error of UNG to NG wasn’t much greater
> for that 6-month period. It gets a lot trickier now.
>
> 1) Contango had been 3-5% from April-July, but has ballooned over
> past 3 weeks to 11% currently. We are currently in the middle of
> the UNG roll period. If it stays this high, that’s an ugly negative
> roll yield to take each month.
>
> 2) Next we have the UNG fund currently not issuing new shares despite
> recent approval. Instead, managers are currently examining investment
> alternatives, such as swaps and soon-to-be-regulated futures contracts.
>
>
> 3) There’s the ongoing CFTC debate over new regulation, likely in
> the form of position limits.
>
> 4) NG storage at 3.152T vs estimated storage capacity of 3.789T (per
> EIA). If injection rate avg of past 3 weeks continues linearly, it
> is expected to exceed storage limit in mid Oct, which is not the
> end of typical injection period.
>
> 5) Energy prices in general are influenced by the general market,
> which looks tired.
>
> 6) Finally we have a trio of storms heading across the Atlantic.
>
>
> Regarding playing FCG instead of UNG. . . Charting OIH vs FCG over
> 1 year period. is a good correlation. OIH holds a large component
> of international and deepwater oil drilling, which is attractive
> and my preference.
>
> Long term, it seems beyond question there will be stronger NG prices
> next year given the depletion rate characteristics for active shale
> fields coupled with reduced drilling. Short term, is a tricky call.
> You know traders will be jockeying for position with these storms
> Monday.

Aug 18 06:11 PM