Natural Gas: Worst Investment Ever?

By Dave Nadig

I love the S&P reports. They always focus the mind. The latest one, covering commodities, focused it on two unlikely candidates—lead and natural gas. Guess which one smells worse?

This was the chart that grabbed me from the latest S&P GSCI report, which comes out quarterly covering the commodities markets:

click to enlarge

This chart shows in stark, stark detail the craziness that is being a commodities investor. It looks at the total return of a fully collateralized position in a particular futures market (dark blue bar) vs. that same return minus the spot return (light blue bar). If the bars are the same length (as it nearly is in live cattle), that means that the spot return—the actual price of cows on the hoof—was completely flat, and the only return investors had (negative, in the case of Bessie) was from the combination of roll yield (the cost or benefit of contango or backwardation in the futures contracts), and the minimal interest earned on a notional collateral position. If the bars are unequal (like lead, for instance), the difference between the two represents gains in spot price. In the case of lead, the 120 percent year-to-date windfall has been almost entirely due to spot prices.

But the way I like to look at this chart is to think of it as the cost (or benefit) of being a futures investor, regardless of spot prices. That’s what those light blue bars represent. So in the case of crude oil, playing crude through futures costs you almost 60 percent. Spot crude has essentially doubled this year, moving from the low $30s per barrel to a recent holding pattern around $70.

Futures investors missed out on that entire run, thanks to having to roll their positions each month.

But the biggest goat by far here has to be natural gas. While in “what if” terms crude oil investors got robbed, the reality is they’ve essentially stayed even, maybe even up a few percent, depending on when you got in.

Natural gas investors have had absolutely the worst of all worlds. Not only has the spot price just been slaughtered this year—from around $6/MMBTU at the beginning of the year to around $3 now—the contango in the natural gas market has been crippling, meaning not only were you an idiot for being in natural gas, you were even more of an idiot for being in natural gas futures.

Don’t take that the wrong way—the market doesn’t mince words. Every trade has a hero and a goat. Maybe you were a genius because you were short natural gas futures.

What’s the relevance to ETF investors? Well, for the first time in history, there’s a very real chance you could have participated in this craziness directly with your Aunt Mildred’s retirement account or your daughter’s college fund. Every one of the commodities I’ve mentioned has a futures-based ETF available (you can even invest in live cattle if you’ve got access to London, with the ETF Securities Live Cattle ETF [London: CATL].

That run in lead could be had with the iPath Lead ETN (NYSE: LD), and we all know the big players in oil and gas (NYSE: USO and NYSE: UNG, respectively).

But there’s a deeper lesson under the hood in natural gas. I can tell you stories about how it’s classically seasonal, and how people make a killing trading it. I can even spin you a yarn about how it’s the cleanest of the fossil fuels, and how its eventual scarcity will make longs rich. But the futures market trumps all.

I can’t possibly say it better than S&P’s GSCI team did in this month’s report:

“Natural gas is probably the best demonstration of the ‘no free lunch’ law in commodity indexing, as evidenced by the S&P GSCI Natural Gas Index which commenced at 100 in January of 1994, ended September at 2.63. Over the same period, the natural gas future has increased about 125%. While 2008 served as a strong reminder ‘to know what you own,’ 2009 has reminded investors ‘to know how to be properly exposed to commodities.’”

100 to 2.63 in 15 years. Now that’s podracing.

Original post

Comments

[Mad Hedge F...:]

cde Happy as I am to open beer bottles with my teeth and do my own tattoos, I have recently become a wimp when it comes to trading natural gas futures. I managed to warn my readers that a collapse of Biblical proportions was coming on June 2, when I recommended a sale at $4.40 (click here for the report at www.madhedgefundtrader...). Yes, you may fan me with ostrich feathers like a Middle Eastern potentate for that call. No, I did not predict a $1.90 bottom by throwing a dart at a dartboard. I simply called a half dozen buddies from my drilling days in the Texas Barnet shale and came up with a worst case cost of production of $2/MBTU. As it turned out we got a $2.40 bottom, and then a to $5/MBTU in a nanosecond, obviously the mother of all short covering squeezes. The industry is still on the horns of a massive dilemma. More than 100 years of supplies of CH4 have been discovered recently, but all of the main production companies may go under before we get much of it out of the ground if prices don’t stabilize. Virtually all natural gas storage facilities in the country are either full or locked up by hedge funds, and it is impossible to export the stuff. Many shareholders have recently found religion, praying for a cold winter to balance out supply and demand. Long term, my bet is that the Pickens Plan (click here for my chat with the homespun Boone at www.madhedgefundtrader... ) and pushes prices back up. If you still want to play where traders gulp down a quart of hot steaming volatility before breakfast every morning, e-mail me at madhedgefundtrader.com and I’ll tell you how to get set up. Just keep in mind, though, that you are moving into one of the toughest neighborhoods in the financial markets, where the “widow maker” lives.

Oct 06 01:51 PM

[Joseph L. S...:]

A very tantalizing, if inaccurate, headline!

Both the author and the commenter above have given a fine recitation of the recent HISTORY of natural gas prices. But what of the FUTURE?

If I invested on March 3, 2009 based upon what the market "had done" recently, I'd have entered short sales. (Instead my decision on March 3rd is right out there in an article on SA, forever to either embarrass me or increase my net worth.)

One cannot drive intelligently by looking only in the rear-view mirror. And one cannot invest intelligently based only upon yesterday's close.

I believe those "overflowing" storage facilities will be emptied rapidly as winter approaches. And the squirrels, bears, birds, bees and other animals whose lives depend upon predicting the severity of the winter here outside our mountaintop aerie (7000 feet at Lake Tahoe) agree with me...

“The present is never our goal: the past and present are our means: the future alone is our goal.” -- Blaise Pascal

Oct 06 02:08 PM

[notsosmart:]

all you can say about the past 2 years is never have so many self named experts been wrong in so many areas.i remember when at&t was broken up into the baby bells & my broker said sell the babiies & keep at&t.i kept them all & lucent paid off my house 10 years early..i learned then-think for yourself as all have an agenda & its not putting money in your pocket.now i do well listening to no one.

Oct 06 03:08 PM

[Erichz:]

It may have been the worst investment ever, but only if you put your money into it and went to sleep. Natural gas has provided many opportunities this year to profit nicely, if you picked the right entry and exit points without being greedy. This has worked well for me so far. I think there will be more opportunities in NG this winter. Even with the oversupply I think NG will tighten. It is already starting to be a bad winter, with furnaces kicking on in early October in most of the midwest.

Oct 06 04:35 PM

[untrusting ...:]

A few problems with your comments.
1) Commercial use of NG is a large part of big NG usage (something like 30-40% if one remembers correctly). Overcapacity in big commercial users like chemicals (DOW), steel ,etc exists, and will not be coming back anytime soon. Unless you happen to believe that the US will return to massive growth almost immediately. DOW Chemical shut-down dozens of plants this year and has no plans to bring them back anytime soon and DOW was a hugh commercial NG user. Let alone that DOW acquired one of their competitors and will be cutting even more in the usual merger cost reduction game.
2) New technology - the new exploration technology for NG has resulted in massive new supply in the US. To argue that NG prices will increase with hugh new supply available is like making the computer price increase arguement. Computer prices have been dropping for years now because techonolgy produces them more efficiently and much cheaper. The same can likely be said about NG due to technology. Thus, it would be surprising if NG prices do not stay low for a considerable time going forward.
3) Dollar declines - even if the dollar decline continues, NG does not need to be imported due to the hugh new domestic supplies, so on would not expect the dollar decline and liquidity driven nature of other asset prices increases to have anywhere near the same effect on NG.

In short, NG does not look a very good bet for much price appreciation in the US going forward. In fact it may well stay near the recent lows for years to come.


On Oct 06 02:08 PM Joseph L. Shaefer wrote:

> A very tantalizing, if inaccurate, headline!
>
> Both the author and the commenter above have given a fine recitation
> of the recent HISTORY of natural gas prices. But what of the FUTURE?
>
>
> If I invested on March 3, 2009 based upon what the market "had done"
> recently, I'd have entered short sales. (Instead my decision on March
> 3rd is right out there in an article on SA, forever to either embarrass
> me or increase my net worth.)
>
> One cannot drive intelligently by looking only in the rear-view mirror.
> And one cannot invest intelligently based only upon yesterday's close.
>
>
> I believe those "overflowing" storage facilities will be emptied
> rapidly as winter approaches. And the squirrels, bears, birds, bees
> and other animals whose lives depend upon predicting the severity
> of the winter here outside our mountaintop aerie (7000 feet at Lake
> Tahoe) agree with me...
>
> “The present is never our goal: the past and present are our means:
> the future alone is our goal.” -- Blaise Pascal

Oct 06 05:53 PM

[THofler:]

Clearly UNG has been a train wreck, partly because the serious futures traders rob the fund blind on its three roll-over days per month.
(And the contango hurts greatly.)

However, if you had picked up the Chesapeake convertible preferred (CHK-D) in the 50's several months ago, you now have a 50% gain and have collected a few juicy dividends.

Oct 06 11:56 PM

[Alan Young:]

While I'm not an expert on commodities investing, this is the first I've heard of "futures investors... having to roll their positions each month." Some ETFs, like UNG and USO, roll monthly. But USL holds 12-month, not 1-month contracts. While USO is down 50% in the past year (since 10/6/08), USL is down only 30%. Surely there are other possible investment strategies, not so readily amenable to indexing, that would not be down at all.

Oct 07 01:58 AM

[Johnni:]

Thanks for a super article!
What I take away from this article is how damaging thee roll over during contango, can be in the commodity futures markets.
I guess this is the opportunity cost for an investor who wants a commodity pure play.

Given what we see here, would it be fair to stipulate that a broad basket of say equal weighted stocks fx. in the NG sector, would be better than the UNG in terms of tracking error vis-à-vis the spot?

Regards

Johnni

Oct 07 04:04 AM

[tedstr:]

Certainly much has to do with supply...we have more than ever. But the big controlling factor is usage and that is driven by industrial demand, principally electricity. Electricity demand has been dropping for months due to our indistrial over capacity. utilities are slowing generation or switching to coal and hydro plants to preserve margins.

This all makes a perfect storm for Nat Gas prices and a perfect buying opportunity once in a decade. A slight bump in electricity demand will send the utilities back to Nat Gas ASAP and a nice bump back up in price.

Oct 07 08:31 AM

[hcm:]

This is a geopolitical question. What happens to the price of NG if there is war with Iran?

Oct 07 08:31 AM

[Chuck Okie:]

NG has other troubles. Eventually utilities, and large users, will diversify a portion of their supply by entering into some long term contracts for LNG. Global iquifaction plant capacity has been increasing at the +/- 25% for the last few years and five years ago (before the capacity increase) the breakeven point for shipping and re-gasifying was in the $3-4 per MCF. This creates a nice margin relative to the retail price and if there is any volatility in the domestic wellhead price, the steady volumes and price of LNG only become more attractive.

Oct 07 08:46 AM

[dano123:]

Call me stupid, but I've been making a lot of money in natural gas over the past few months employing and age old strategy called buy low sell high--works almost every time.

Oct 07 10:20 AM

[Landtech:]

My question is what do the Chinese know that we dont? Why are they haveing success in their ventures with NG and making that commodity work? Perhaps if we just started transitioning over to actually using natural gas more in our lives..uh hum (cars) instead of hoarding it the market might grow here as in China. I have read many articles on this and I actually work specifically in the industry and I see nothing but unsophisticated players too unschooled in the need to unite and create a decent lobby to convert these resources to use.
Where is the marketing and logo for natural gas? ....Im just sayin....

Oct 07 11:26 AM

[lewisabroad:]

I've read a lot of great comments that make sense - money can still be made on nat gas if a good strategy is employed, and there is definitely upside potential if certain conditions are met, but the author's point is that performance to date of NG futures has been awful. Not an issue for the careful and informed day-trader, but brutal for the "Aunt Mildreds" out there - who are able to put their money in a highly volatile market through ETFs in their IRAs without having any idea of the fundamentals. Meanwhile the mutual fund managers are happy to take their fees to the bank...

Oct 07 11:35 AM

[joeevan:]

Agreed...and this is a good time to buy the natural gas MLPs (e.g., AHD, APL).


On Oct 06 02:08 PM Joseph L. Shaefer wrote:

> A very tantalizing, if inaccurate, headline!
>
> Both the author and the commenter above have given a fine recitation
> of the recent HISTORY of natural gas prices. But what of the FUTURE?
>
>
> If I invested on March 3, 2009 based upon what the market "had done"
> recently, I'd have entered short sales. (Instead my decision on
> March 3rd is right out there in an article on SA, forever to either
> embarrass me or increase my net worth.)
>
> One cannot drive intelligently by looking only in the rear-view mirror.
> And one cannot invest intelligently based only upon yesterday's close.
>
>
> I believe those "overflowing" storage facilities will be emptied
> rapidly as winter approaches. And the squirrels, bears, birds, bees
> and other animals whose lives depend upon predicting the severity
> of the winter here outside our mountaintop aerie (7000 feet at Lake
> Tahoe) agree with me...
>
> “The present is never our goal: the past and present are our means:
> the future alone is our goal.” -- Blaise Pascal

Oct 07 12:15 PM

[TBill:]

> I think there will be more opportunities in NG this winter. Even
> with the oversupply I think NG will tighten. It is already starting
> to be a bad winter, with furnaces kicking on in early October in
> most of the midwest.

We blame global warming.... er, 'climate change'.

Oct 07 01:08 PM

[Crude Oil T...:]

Retail investors that lack the understanding of NAV and contracts roll over have been eaten alive by UNG. Just look at the boards on Google Finance etc. But UNG has still been an amazing day trading tool if you know how to avoid the road blocks. Don't get stuck in this one, but use the welcomed volatility when it gets overbought and oversold.

Take a minute to watch Adam Hewison's call on gold > tinyurl.com/y8zgxu7 Worth the watch!

crudeoiltrader.blogspo...

Oct 07 01:08 PM

[nick226:]

What about investing in some of the royalty trusts for 3-5 year horizon? Seems like we're near bottom and nat. gas has alot of upside. Who knows if UNG will even be around in 3 years. Plus most of them pay good dividends...

Oct 07 08:09 PM

[OilFinder:]

Almost nothing.

On Oct 07 08:31 AM hcm wrote:

> This is a geopolitical question. What happens to the price of NG
> if there is war with Iran?

Oct 07 10:02 PM

[Shishir Nigam:]

I'm of the opinion that natural gas is currently in quite a rare situation...given how far it has dropped and such a situation HAS to be temporary. It is currently at an un-natural price and given that there is very likely to be increasing demand from all around the world as coal production is replaced going into the future. The current situation of oversupply may be sufficient justification for the low price but it is very unlikely that this situation can persist for too long.

I would view NG as a definite investment opportunity, though I'd love to hear some ideas on the best ways to translate that into a trading strategy..

For more analysis, check out my blog: youngandinvested.com

Oct 07 10:19 PM

[Scruffy:]

Lets face it, the US is plumbed for NG and when it gets cold (yes Al it will) the NG will flow and flow fast. So your either in the futures for fleece or your sniffing NG while its at the bottom and looking up :-)


On Oct 06 02:08 PM Joseph L. Shaefer wrote:

> A very tantalizing, if inaccurate, headline!
>
> Both the author and the commenter above have given a fine recitation
> of the recent HISTORY of natural gas prices. But what of the FUTURE?
>
>
> If I invested on March 3, 2009 based upon what the market "had done"
> recently, I'd have entered short sales. (Instead my decision on March
> 3rd is right out there in an article on SA, forever to either embarrass
> me or increase my net worth.)
>
> One cannot drive intelligently by looking only in the rear-view mirror.
> And one cannot invest intelligently based only upon yesterday's close.
>
>
> I believe those "overflowing" storage facilities will be emptied
> rapidly as winter approaches. And the squirrels, bears, birds, bees
> and other animals whose lives depend upon predicting the severity
> of the winter here outside our mountaintop aerie (7000 feet at Lake
> Tahoe) agree with me...
>
> “The present is never our goal: the past and present are our means:
> the future alone is our goal.” -- Blaise Pascal

Oct 07 11:34 PM

[thiazole:]

And to add to that, natural gas has a history of bottoming out in the late summer/early fall and peaking out around December. It is a pretty easy trend to trade. I've done it a few times, but this year seemed like a no brainer as cheap as natural gas became recently.


On Oct 07 10:20 AM dano123 wrote:

> Call me stupid, but I've been making a lot of money in natural gas
> over the past few months employing and age old strategy called buy
> low sell high--works almost every time.

Oct 08 12:50 PM

[thiazole:]

The only thing stocks like UNG are good for is buying puts during the seasonal peak. They erode some much on their own that it doesn't take much of a fall in price to really make some serious money. I just bought some puts on USO for the same reason. I may not do UNG this year depending on how much hype there is around natural gas as replacing coal or even gasoline.


On Oct 07 01:08 PM Crude Oil Trader wrote:

> Retail investors that lack the understanding of NAV and contracts
> roll over have been eaten alive by UNG. Just look at the boards on
> Google Finance etc. But UNG has still been an amazing day trading
> tool if you know how to avoid the road blocks. Don't get stuck in
> this one, but use the welcomed volatility when it gets overbought
> and oversold.
>
> Take a minute to watch Adam Hewison's call on gold > tinyurl.com/y8zgxu7
> Worth the watch!
>
> crudeoiltrader.blogspo.../

Oct 08 12:59 PM

[Northstar10000:]

Nat gas stocks are a great place to drop some coin in the bucket.
Just buy slowly using a time frame buy vs a price buy.

Oct 09 11:50 PM

[dieuwer:]

This chart is useless and doubtful as of its accuracy at best.
SPOT WTIC on 01/01/2009 was about $48. As of 09/30/2009 SPOT WTIC was $70. A GAIN of about 46%. Why is this not reflected in the chart???

Oct 10 04:36 PM

[dieuwer:]

With respect to LD, did you check the volume of this ETN? It's 5500 shares on average! With a share price of about $60, the amount of money moved each day in this ETN is $330,000! Very illiquid if you ask me.

Oct 10 04:54 PM