This article will look at how NatGas prices over the remainder of the year may impact investments in related ETFs, since the East Coast freeze has put supplies into a shortage condition and natural gas market prices have skyrocketed. So has the NYSE quote for the ETF ProShares Ultra DJ-UBS Natural Gas (BOIL), a (2x) leverage play on the commodity's price.
Have investors just now looking in missed the boat?
Our eyes on the scene, the Market Makers [MMs] who help big-money-fund portfolio managers make bets on what's likely to happen next make their own bets on what those clients are likely to do with the securities prices. And that's what most other investors want to know, instead of getting drawn into commodities markets' machinations.
So we watch how they hedge the bets they have to make with the firm's capital as they provide buying and selling capacity to facilitate the volume trades the PMs want to get done. The block trade stock MMs don't want any part of those commodities trades, so they hedge away the underlying risks, as they see them.
Other desks at the MM firms are deeply involved, regularly making markets in commodities, so what's going on there is well understood. And the proprietary trade desks rely on inputs from the commodity brokers to help them set the prices they will demand from the block trade desks of other MM firms who are looking for that price insurance to hedge their temporary firm capital exposures on the equity and ETF trades of their clients.
In all of this activity, the varied participants are all angling to make a buck, or several thousand, on every trade they commit to. Somewhere there has to be a source for all of their salaries and bonuses. Usually it comes out of the PM's winnings on his trade - if he is astute enough to identify the opportunity in time to have it earn enough to cover the costs of doing the trade and still leave enough to be a gain for the PM's clients.
Fast and furious, but it is a very serious game with billions of dollars a day rocketing around, subject to a vig here and a vig there. Those prices, and the way they are arranged, tell the true story of what knowledgeable, informed, and experienced players really think. Not what the salesmen are told to tell the customers.
By intensively analyzing the prices demanded and paid for protection by the pros, we can see what the expectations are at this point in time. Then, by tracking how the market quotes perform subsequently, we can tell where the odds have been good that the MM community has known how to assess what's likely to happen next.
In the case of BOIL and natural gas prices, there is a strong seasonal overlay to the commodity price picture. And further, there is an underlying technological evolution taking place in energy resource extraction that greatly influences costs, as well as supply and demand. Here is how the MMs have recently been seeing the NatGas pricing outlook:
(used with permission)
These vertical lines are the ranges of future possible price anticipated, day by day, by the MMs, an ongoing adjusted forward-look rather than the look-back historical pictures presented in most "stock charts." The heavy dot is the market quote for BOIL on the date of the forecast.
Its position, splitting the forecast range into upside and downside parts, has been shown to have some future price forecasting significance. We measure that balance by what proportion of the full range lies below the current market quote, labeling that value the Range Index. Here, it is 23.
When we look at how BOIL prices have moved subsequent to every available day's RI, it is clear that the present position has been quite favorable for 2-3 month interim investments. This table makes that clear:
For Range Indexes less than 29, of which there have been 126, the average price gain in the 60-65 market days of 3 months has been 9% to 11%, compared to an average trendline price change performance in that period of time of zero to -1%. By standard statistical tests, such a difference is highly significant, leaving very little to chance.
Going back to the data line under the blue-background picture, where we apply our standard time-efficient sell discipline of profit-taking as soon as the top of the forecast range is achieved, or holding any position for no longer than 3 months. The 25 prior RI forecasts at the 23-RI level took only 44 days on average that way to achieve their gains, net of losses, of +10.8%. A portfolio that could do that repeatedly would be up by 80% in a year.
One limitation present in this situation is the lack of a 3-year or longer period of forecasts. That is the reason for the red-flagging of that part of the data line. With a longer history, the claim that "now" is substantially more opportune a time than the "usual" is often easier. But in the present extreme weather situation persisting in the heavily-populated East Coast area, unusual is pretty much taken for granted.
The strong lower limits of the forecast ranges in the past week and the demonstrated higher actual price experiences of a couple of weeks ago create an impressive chance that we may see attractive further gains in BOIL in coming weeks as a supply-demand pinch temporarily pushes futures prices higher. And it is such futures that BOIL tracks.
The MMs' upside target of +26% is far above the average achievement, but these are not normal times. Still, "bears make money, bulls make money, but pigs get slaughtered" is a Wall Street maxim worth remembering. Despite the MMs' enthusiasm, we would be a lot more comfortable with a smaller, more average target.
So much for what may transpire near at hand. What can we learn of how the rest of the year may play out, and what may be a longer-term NatGas outlook? Much is going on in this corner of the energy industry that will infect the rest of the oil patch.
The advent of horizontal drilling, accompanied by hydraulic fracturing of shale beds (fracking) has released far greater quantities of natural gas than anyone ever expected as little as five years ago. As extraction technologies advance, the at-surface costs of 1-million BTUs of heat energy have plunged. The Marcellus beds in western New York, Pennsylvania, and Ohio are geographically close to major US electrical demand centers, so the delivered costs of this generating fuel can easily undercut the former widely-used fuel, coal, and avoid many of its associated ecological problems.
On the other hand, coal will find ways to compete, and this puts a ceiling on what NatGas will be able to charge. And low transport costs for NG depend upon long-term demand contracts in order to obtain pipeline construction financing. So it's not a slam-dunk for producers of natural gas.
The other big natural gas market in development is in transportation. Already major delivery and other restricted-distance route transporters are moving wholesale to NG-based fuel, and engine manufacturers are improving their product lines to meet the rising demand. Over-the-highway distance truckers are quick to recognize investment payback economies of less than a year, but are limited by available distribution systems.
The advent of widespread use of NatGas as a fuel for personal transportation is severely limited by the lack of widespread easy availability, and the established producers of gasoline have a negative motivation in undercutting their principal source of revenue and profit here in the US. Since those producers control the principal roadside vendors of gasoline, there will be great resistance to the spread of NatGas refueling outlets. The symbiotic relationship between automobile manufacturers and gasoline producers may continue to play a part in that resistance.
While Exxon Mobil (XOM) and other major petroleum producers are major factors in natural gas production, the producing industry has quickly become far more fractionated than in the "seven sisters" days, when establishment producers could exert crushing control over rebellious actions of insurgents.
The majors will long have enormous influence at the federal level via DC lobbying, but some of the disparities presently existing in fuel heat content pricing are eventually going to be overwhelming. As that occurs, investment selectivity among energy producers will become extremely important, favoring those that have little to lose from gasoline price reductions.
So what can be learned from energy industry hedging stances involving exposures later in the year 2014? The same analysis that provides implied price ranges nearer at hand, as in the discussion above, has parallels for the 3rd and 4th calendar quarters of the year. While it would be reasonable to expect that current-day forecasts are inflated by temporary pressures, that is apparently not the case.
Price ranges now expected from $46 to $63 for BOIL are $43 to $63 in September, before the heating season begins, and $45 to $70 in December.
It appears that there remains attractive further upward price moves in BOIL, near term. We would generally counsel being opportunistic rather than demanding in seeking satisfaction, with half the forecast gains being a pretty good target, particularly if achieved promptly.