Misguided Thinking on Natural Gas

By Dave Nadig

Don Dion, publisher of Fidelity Independent Advisor and related newsletters and manager at Dion Money Management, is generally one of the smart guys in the room. But his recent call on MLPs seems off the mark.

Don’t get me wrong, you could do a lot worse than to follow Dion's advice. But his take on what's going on in the United States Natural Gas ETF (NYSEArca: UNG) seems a bit wrong-headed.

On Monday, Dion posted an article over at TheStreet.com boldly titled "A Natural Gas ETF to Play Contango."

Based on the headline, I assumed this was either:

• A way to make money if natural gas goes up.

• Or, a way to make money if natural gas contango disappears.

Instead, it's an introduction to the JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ). To be fair, it’s a good introduction to AMJ, the only good way to play oil and gas Master Limited Partnerships. I’m actually a fan of AMJ, because it does open up an asset class traditionally hard to get into.

But the disconnect between the premise (an alternative way to get natural gas exposure) and the fund he’s talking about is profound. Dion’s claim that it “offers investors exchange-traded exposure to the natural gas marketplace without the problems of United States Natural Gas (NYSE Arca: UNG)” is a bit like saying General Motors gives you exposure to the industrial metals markets — not strictly wrong, but completely irrelevant.

The problem is simple: oil and gas partnerships are in the transportation business. They get paid for moving oil and gas around. They are operations companies which make money by managing infrastructure well. While there are exceptions, for the most part, they are ambivalent to whether natural gas is expensive or cheap.

In fact, you could make the case that if natural gas gets even more expensive, MLPs will actually suffer because less gas will be consumed.

In reality, however, the historical performance of MLPs is entirely uncorrelated to gas and oil. Wachovia put out an excellent 100-page research report on the topic last year, and here was its findings:

MLP Correlations With Other Asset Classes

Asset	2007	July 2007-July 2008	3-Year	5-Year
S&P 500	0.43	0.43	0.43	0.40
Natural Gas	0.02	0.10	0.13	0.14
Crude Oil	0.26	0.34	0.31	0.31
10-Yr. Treasury	0.24	0.36	0.19	0.07
Utilities	0.36	0.29	0.41	0.40
REITs	0.35	0.21	0.30	0.32
Corporate Bonds	0.03	-0.01	0.00	-0.0

Data: Wachovia

To pick out just one data point, the three-year correlation of MLPs with Natural Gas was 0.13. (Which is to say, nothing.)

Of course, you don’t need to look at fancy-pants correlation math to see this -- you can just look at the chart. This is the performance of UNG vs. the Allerian MLP index over the past few years:

In fact, what you see so far in 2009 is the strong negative correlation: the MLP index is up 25% for the year, whereas UNG is down over 60%.

Of course, since the MLPs themselves are traded, there are multiple arguments you can make as to why they went up. But it strikes me as reasonable that it’s predominately for the right reasons — they’re huge income generators in an environment where yield’s hard to find.

But are they a play on natural gas contango?

Sorry Mr. Dion, there’s just no real evidence to support that theory. Natural gas could double in price and swing into backwardation and most MLPs wouldn’t really care. Unless there’s a massive disruption in actual natural gas supply and demand (and there really hasn’t been during this tremendous run-down), MLPs will keep doing what they do: print money slowly.

Original post

Comments

[zorro6204:]

Sorry, but your logic has holes as well. First, SOME MLP's are involved in transportation only. Many are producers, including LINE, VNR, LGCY, ENP and PSE. And even more combine transport with processing, including NGLS, EVEP, MWE, CPNO and many, many others. The "exceptions" are quite numerous!

And many MLP's do not conduct a fee-only business for gas transportation, they are paid in liquids removed from the gas. While NGL's do not necessarily track the price of gas, to say that MLP's are insensitive to price movements is incorrect.

Finally, even if a given MLP derives all of its income from fees for movement of gas only, their income is still very much affected by the price of gas, because price affects drilling, and drilling is what provides gas to move.

As to why the price of MLP's often seems unrelated to commodity prices, just look at PSE or LINE; hedging. If you average commodity prices over four years, try the chart again, though there is bound to be a discontinuity for the "great recession" crash.

Sep 03 05:05 PM

[Mad Hedge F...:]

dfnn. Just when I get comfortable with my view on Natural Gas, I get a scratchy, reverberating cell phone call from one of the major formations telling me that I’m being way too bullish. Gas won’t bottom at $2. The free fall will continue until it hits $1. National storage will be completely full imminently top out, and when it does, the producers will have to shut down completely. Since these guys are leveraged up the wazoo, this will trigger a string of bankruptcies, and the majors will fall like dominoes. A hedge fund bust won’t define this bottom, as these guys are all playing from the short side. UNG can’t step in as a buyer of last resort, as the SEC won’t let it issue more stock, and the current shares are trading at a ridiculous 20% premium. One thing we do agree on is that the bottom will look ugly, whatever the spark is. You often get Armageddon type views near market bottoms, but this guy has been dead on right until now. Well, it takes two to make a market. Conclusion: keep NG nailed to your screen, as the widow maker is where the volatility lives.

Sep 03 06:52 PM

[Tack:]

I just love it when any sector is driven into the dust, accompanied by the usual predictions of endless doom and a futureless landscape. It just makes finding the next buying opportunities that much simpler.

Sep 03 07:20 PM

[mbkelly75:]

That eBook (report, whatever) from Wachovia is probably the best way to learn about MLPs and why they belong in your portfolio. Regardless of what they actually do - that they have a consistent low-correlation with both Stocks and Bonds (and most pay a terrific dividend) makes them a plus for your portfolio.

Sep 03 11:54 PM

[mplaut:]

You have nailed it: "...they’re huge income generators in an environment where yield’s hard to find."

Many of the MLPs with solid distributions pay a yield that is so high (more than 10%) that you can be happy with the yield as a yearly return on your money and you do not have to worry about price.

Yield is determined by analyzable aspects of the business. Price is a function of (mass) psychology. Which would you rather be dependent on?

Sep 04 07:55 AM

[losbronces:]

To quote you: "AMJ, the only good way to play oil and gas Master Limited Partnerships."

How is an ETF that charges a fee and pays a fully taxable dividend in place of the tax advantaged distributions of MLPs the only good way to play the sector? I admit to owning AMJ in a 401K, but unless I had very limited funds I wouldn't own it in a taxable account. So it has a place, but it is certainly not the only way nor is it necessarily the best way to gain exposure to the high yield MLPs in the energy business.

In addition, it is as thinnly traded as the smaller MLPs, averaging less than 200,000 shares /day.

Sep 04 01:39 PM

[Boffilicious:]

"they are ambivalent to whether natural gas is expensive or cheap." Yeah but not ambivalent to profits from storage and transportation is a form of storage... right now buying NG spot at $2.5 and sell for Nov at $3.75 provides annualized yield of staggering 600%. Hence whilst UNG will likely lose 40% of its contracts to Roll Yield Loss over the coming 4 months (declining from 107,000 equivalent NG front month to 60,800 equivalent NG front month by January roll if the contango remains), those with access to storage like Chevron, Centaurus and MLP's will flourish.
MW

Sep 05 08:11 AM

[Boffilicious:]

I think this proves the point well!!
www.riskcenter.com/sto...

Sep 05 02:17 PM