Natural Gas In Extreme Backwardization; Expect Prices To Fall And National Focus To Turn Towards More Production

Feb.24.14 | About: The United (UNG)

Executive Summary

  • Natural gas futures are showing extreme "backwardization"
  • Natural gas April contracts are selling at a 40% discount to March
  • The natural gas shortage will likely generate investment opportunities, especially in infrastructure
  • 2014 is an election year, and energy policy is certain to play a part in determining who controls Congress

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I recently wrote an article about natural gas when it was just breaking $5. The thesis of the article was that the spike in natural gas prices was likely only temporary being due to short-term weather related issues.

Identifying temporary price spikes doesn't necessarily mean you can capitalize on them. The problem is natural gas futures are in a situation called "backwardization," and in the current case, extreme backwardization. This graphic from the video that inspired this article highlights how, as predicted, natural gas prices are almost certain to fall in the near future.

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Currently the April 2014 Natural Gas Futures are selling 40% below the price of March 2014 Natural Gas Futures. Each month after March, differ by almost negligible amounts compared to the Mar/Apr spread.

Month Price % Diff
Mar 14 $ 6.23
Apr 14 $ 3.73 -40.2%
May 14 $ 3.83 2.7%
Jun 14 $ 3.84 0.2%
Jul 14 $ 3.81 -0.8%
Click to enlarge

Unfortunately, it isn't that easy to capitalize on what appears to be such an obvious trade. Unlike the VIX ETFs that are giant black holes for money because they are continually buying into a "contango" situation, backwardization doesn't present the same opportunity. Under the contango situation, futures sell at a premium to the cash. That means that if nothing changes but time, as expiration approaches the futures contract is guaranteed to lose money as it converges downward towards the cash. Buying into contango is like continually buying high and selling low. This graphic of the VIX ETN shows just how devastating that can be for returns.

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The obvious solution is then to buy the ETN that shorts the futures in a contango situation. This graphic shows how much better the inverse VIX fund does than its cousin shown above.

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Under backwardization futures sell at a discount to the cash, so you are always selling high and buying low. If nothing changes between the time you buy and expiration you are guaranteed to make money, the futures contract will converge upward towards the cash price. Sounds like a sure win situation, but it isn't.

My first thought was that maybe there was a way to short the United States Natural Gas Fund ETF (NYSEARCA:UNG) or buy the ProShares UltraShort Natural Gas ETF (NYSEARCA:KOLD) to capitalize on the 40% difference between the Mar and Apr contracts. That idea however works better on paper than in reality. The reason is the March contract will expire and be converted to cash. The March contract isn't going to converge towards the Apr expected cash price, it's going to converge towards the March cash price, and right now there is an extreme shortage in the natural gas market. The April contract is out beyond the expected shortage period, and the April contract is going to converge towards the expected April cash price, which is currently about 40% lower. UNG isn't going to show a 40% drop when it rolls its March contracts over into the April contracts, it will simply own 40% more April contracts than it did March contracts. The fund assets and NAV will remain the same. There is no opportunity to gain from the difference in March and April futures prices by buying the ETN. Because the UNG only holds the current month contracts, the only gains to be had are gains and losses in the individual contract.

If there is a way to profit from the extreme backwardization in the natural gas market using ETNs I haven't found it. I would caution people from taking the advice of people recommending shorting natural gas using the ETNs. The futures markets have already discounted the fall in prices as I explained above.

While that investment concept won't work, the video did however identify likely future investment opportunities.

at this point, the majority of increases behind us, unless this weather continues...it's important for consumers to understand what we're seeing in natural gas futures market is a trade. looking at this big spike in the march natural gas futures contract. that spike has not occurred in april or the june contract...and it's largely due to the weather, but also due to the infrastructure and the pipeline issues we have in getting all of that shale gas, talking about this natural gas boom. Yeah, we have great production and a lot of natural gas, but getting it to the right place has been the problem. And how are we -- to Sharon's point, how are we even having this conversation about supply and demand given the amount of gas we're producing in shale territories? Sharon makes a great point. Sometimes it's not about just having it in the ground, once you get it out, the right place to store the natural gas. It seems absurd we can't get it from point a to point b, fast enough to even having a supply/demand discussion in this country at this point. That's the beauty, it creates an awareness and get some of the projects that were shelved back on the drawing board. I think in my mind, what this will eventually do is spur some of that investment that was very much needed.

The video highlights the complete "absurdity" (their words, not mine) of the current situation, and points out how natural gas is being "flared" off in the shale gas areas while there is a shortage elsewhere.

BISMARCK, N.D. - About 30 percent of North Dakota's gas production is being burned off because development of the pipelines and processing facilities needed to handle it has not kept pace with production.

That's gas that was 46 percent more expensive Wednesday than it was at the beginning of the year.

The state is losing nearly $1 million monthly in natural gas tax revenue as vast amounts of the byproduct of oil production goes up in flames.

So much gas is being flared off it can be seen from outer space.

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This issue more than any drives home the "absurdity" of this Nation's current energy policy. While the US and other European Nations are off tilting at windmills pretending that they can somehow control the ever changing climate, this winter has exposed that the US is totally unprepared for the real climate threats facing this Nation, and they aren't related to warming or CO2.

This winter is acting like a cold shower and slap in the face after this Nation has gone on a misguided drunken global warming spending binge. We've spent fortunes on wind, solar and ethanol, but ignored the most important, reliable, abundant and needed sources of energy we have, natural gas and coal. America was so unprepared for this winter there is even a shortage of road salt.

It is because of this absolute "absurdity" that I would expect Washington to either wake up, or get a punch in the gut during the next election. This winter is almost certainly going to force this Nation to take a different direction when it comes to energy. Wind and solar do absolutely nothing for the freezing people in the North East that heat their homes with natural gas and rely on electricity from natural gas and coal burning power plants. Because of this I would expect projects like the Keystone XL Pipeline to get approved and create plenty of investment opportunities in the future. The big problem with that theory however is that if President Obama does approve the Keystone XL Pipeline, he may be risking $100 million in contributions towards the cause.

A billionaire retired investor is forging plans to spend as much as $100 million during the 2014 election, seeking to pressure federal and state officials to enact climate change measures through a hard-edge campaign of attack ads against governors and lawmakers.

The markets aren't waiting for the next election however and already investment gains are being made in certain sectors. Like a scene out of Atlas Shrugged, the Northeast, after having demonized evil coal, is now clambering to import coal for their mothballed coal burning power plants. Coal and the rails that carry it are rushing to save those who have worked to destroy them. The people in the Northeast can now see the true folly of their ways, and won't likely continue to support policies that so clearly would have had self-inflicted catastrophic consequences had they been fully implemented. During a climate/weather crisis, the Northeast didn't rush to import wind turbines and solar panels, they rushed to import coal. The importance of that act can't be overstated, and it will likely create opportunities for investors. While the Northeast may have dodged a bullet this winter, if cold winters continue as some predict, the winners will be obvious and they won't be wind and solar.

A note out Friday from J.P. Morgan analysts points out how, beneath all this winter's snow, railroads are emerging as a rare investment opportunity. Here's why.

Severe cold has sent natural gas prices soaring 45% since the start of the year, which in turn drove up the cost of generating electricity using gas-fired turbines. That prompted some utilities to fire up their old coal-burning units while those with newer, dual-fired power plants simply switched from pricy gas to cheaper coal to keep down generating costs.

This surge in demand has shaken coal prices from their long slumber. Since last summer, Powder River Basin coal prices are up about 19% and Central Appalachian prices are up nearly 25% as utilities replenish their stockpiles. The steepest price spike was seen in December, when the first blast of arctic air hit the East.

In conclusion, having a shortage of natural gas during a time when we have an abundance is an "absurdity" of epic proportions. Not since the heydays of the old Soviet Union Central Planners has there been such a monumental misallocation of resources. America however isn't the old Soviet Union, and I doubt she will tolerate such "absurdity" much longer. U6 unemployment near 13%, regional shortages of natural gas and the pipeline's construction being blocked isn't the kind of campaign theme that wins elections, and 2014 is an election year. I would expect a much softer tone from Washington towards coal and natural gas going forward, and that will create investment opportunities, at least up until the election or people have forgotten how important coal was in getting them through this winter. By then however my bet is they will be reminded by another severely cold winter.

Hiding the Evidence

Pedersen said climate scientists know the Earth stopped warming 15 years ago. But the United Nations Intergovernmental Panel on Climate Change, of which Pedersen is an expert reviewer, suppressed a recent report from its own scientists that the U.N.'s climate model has been proven wrong.

"In particular one of the issues has been why global warming has stopped during the last 15 years, and climate scientists were very frank that the climate models do not match the climate we observe," Pedersen said.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.