I had posted an article on March 14, 2012, Natural Gas: Possibly the Best Trade of 2012 Fast Approaching, which discussed the direction of price movements we can expect in natural gas for the next 3-6 months.
And for those of you who don't want to jump to another page here is the main argument of that article:
Although there are some fundamental reasons behind the fall in natural gas prices, because of the long and persistent downward trend technical factors have taken over. In that environment only a capitulation event will turn around the main trend. However, the good news is, that capitulation event seems to be quite close to happening.
For some reason my article generated a very high amount of page views and comments. There were some very good replies from some people who were probably much more knowledgeable about the subject than me. However, there was a fundamental misunderstanding that I noticed. Many of the commenters, and probably other people, who have read the article failed to understand the gist of the article. What I was arguing for was a trade rather than a projection about the fundamentals of natural gas. It was not a short-term speculative trade, but it was still just a trade. My suggestion was based on the fact that prices and fundamentals can significantly differ and in order to make profitable trades you had to realize that fact.
Below I will try to correct that misunderstanding by answering some of the questions raised in replies to my original article. Hopefully my responses will give rise to another good discussion session in the comments section, as happened with the original article. I thank all of the knowledgeable people who responded to my article and raised some good issues. I am proud to offer my responses to some of them below:
Critique: The United States Natural Gas ETF (UNG) is not the right investment vehicle to use for investing in natural gas.
Well it depends. Many of the comments suggested using pipeline companies, royalty trusts, or production companies instead of UNG. It is important to note that none of those options are a direct play on the price of natural gas. My predictions were based on an extreme downside movement in the price of natural gas. The pipeline and production companies haven't experienced the similar price movements along with natural gas, hence their participation in the upside will be limited as well.
UNG might have its drawbacks but, if an alternative is to be used it has to be a direct substitute to the function of UNG. The drawbacks of UNG mostly arise from the fact that there is some extreme contango in the natural gas market. This is just a feature of the market, not the fault of the UNG. Natural gas is a hard to store commodity and it is widely expected to appreciate in the future. Those two reasons cause the contango. You should also consider the possibility that any sudden shift in the price expectations can switch the market from contango to backwardation which would make the UNG a better investment. Also if you consider the similar Oil ETF (NYSEARCA:USO) you will realize that it has done a relatively good job of tracking the price of oil.
Given USO has the same structure as UNG it should be apparent that UNG's drawback arise from the state of the natural gas market not the structure of the ETF.
Basically, UNG might have its drawbacks but there doesn't seem to be that many alternatives that will give the 550% return if natural gas goes from $2 to $13. At least not many alternatives that are as easy to invest and liquid as UNG.
Critique: The extreme decline in the price of natural gas is purely due to fundamental reasons. The price won't turnaround until LNG export facilities are operational or coal plants are switched to natural gas.
While this argument is correct on a fundamental basis, the effect on natural gas prices won't be as simple. One should consider that markets are a discounting mechanism for future events. Many of the barriers to more widely use of natural gas are regulatory. The market currently forecasts that the approvals of these additional uses are a couple of years into the future and therefore they are uncertain. Any indication that these measures will clear the regulatory and financial hurdles will have a very sudden and strong effect on the prices. If you wait for the approval and build out of these measures, and the resulting effects on inventories, the price of natural gas will have long been back to $10 by then.
Critique: Pipeline companies are the way to invest in the rebound in natural gas.
Many pipeline companies and royalty trusts are leveraged finance vehicles. They use a lot of debt in building out these infrastructures and whatever they earn between their revenues and costs of debt they pay out as dividends. The problem is these companies are highly regulated. Therefore contrary to one might expect these are extremely stable companies (at least their dividends), unlike the prices of commodities they transport. That is why they stayed relatively unaffected by the decline in natural gas prices. The fact that natural gas has lost 80% of its value does not mean pipeline companies charge one fifth of what they were charging. However, when natural gas turns around, the opposite will be true and they won't get to participate in the upside as much as the natural gas itself.
As a common rule, pipeline companies and royalty trusts are much more sensitive to developments in the interest rates than the prices of the commodities they transport.
Critique: Technicals don't play a role in the price action. It is just about supply and demand and the fundamentals of natural gas are really as bad as the price suggests.
On this topic I will admit that I am probably not well qualified to comment on the details of the natural gas industry. However I will mention this. In my opinion, the fluctuations in the price of oil, silver and gold since the financial crises have effectively ended the debate whether the price of energy resources and metals are just a function of supply and demand. The simple fact is speculators and technicals do have a huge role. In the case of natural gas, the technicals are just terrible unless capitulation occurs. In addition, financial markets do work on herd mentality so for many investors the fact that natural gas is in a strong downtrend is reason enough to stay away.
Critique: Natural gas should be utilized more effectively and widely, given its low price relative to other energy sources.
This is not that simple either. You should not assume that once those additional uses are in place the price of natural gas will remain the same. Probably when those additional infrastructure investments start to be deployed, natural gas prices will start rising very quickly and it will lose its price advantage. As mentioned previously, the reason natural gas market disregards those possible additional uses is that the market assumes them as very uncertain. The abundant supply will somehow balance the upward push to the prices. However, I am still doubtful that natural gas prices will remain at $2 if America starts to make better use of it.
I hope this clears up some of the issues in my original article. I would like to thank all those who have participated in the discussion in my original article. I hope these responses will stir up another set of quality replies.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in UNG over the next 72 hours.