Natural Gas: Why This UNG Rally Is Not Sustainable

| About: The United (UNG)

I had argued in one of my previous articles that natural gas and hence the Natural Gas ETF (NYSEARCA:UNG) was close to forming a capitulation bottom. That article was extremely popular, but also very harshly critiqued due to the strong contango in the natural gas market.

Natural Gas: Possibly The Best Trade Of 2012 Fast Approaching

Since then, UNG has appreciated by almost 30% from its bottom near the $14,24 level.

However, I wanted to write this article to establish that the recent rally in UNG is not the capitulation rally that was mentioned in my article. I would like to elaborate on, why I expect this rally in UNG to fade, and why the more sustained capitulation rally will happen later in the year in 2012.

The main thesis of my original article was that, long trends like the one natural gas has been in for the last 2 years, only change course with a capitulation event. In more practical terms, to mark the end of such a strong trend, there needs to be a 10 -13% downward correction in a single day in which many natural gas longs would finally give up. Then, the contrarians would start to move into UNG which would mark the start of a sustained rally from that capitulation event.

However, the bottom we had in natural gas is not consistent with such a capitulation event. It did not have that huge down day followed by an equally impressive upside in the following two days that is characteristic of a capitulation.

One important factor to consider is that, in order to profit from a long UNG position, natural gas needs to appreciate at a very high pace. The natural gas market has a very strong contango and this causes the UNG to lose its value if natural gas prices stand still. Only the strong rally after a capitulation bottom will make it profitable to get long UNG. That capitulation will occur and the following rally will be more than enough to make UNG profitable even with the loss to contango. However, the bottom in early May of 2012 is not the one to trade, in my opinion, because of its softer formation.

My explanation for the rally in UNG is that, many funds closed out their pair trades as the market has taken a downturn in early May of 2012. Many fund managers hedge their long positions in popular stocks with an opposite trade in assets like UNG that are expected to decrease. That pair trade supposedly decreases the sensitivity of the fund to changes in liquidity. However, when the long positions start to decrease in price, the funds unwind the pair trade which amounts to covering up the short position in UNG. I have written a more detailed article on SA about this which is below:

Why Heavily Shorted Stocks Might Rise In A Market Swoon

I would suggest that any profits made from the rally in UNG, should be realized soon. A more sustained bottom will only be established after a strong capitulation. Even if natural gas prices just stabilize, UNG will probably start to decrease due to the losses to contango. Investors are much better off to wait for a bottom that has the true characteristics of a capitulation. When that bottom forms, the following strong rally will make long positions in UNG hugely profitable.

As a separate disclosure, I have received some private messages asking for more specific trading advice. I am hesitant to do that because I am not a RIA in the US. A much more efficient way for would be to use the "Follow" feature on SA for investors who find that my trading suggestions are of good quality. I try to write posts about almost all of the trading opportunities that I can come up with anyway. As a result, there wouldn't be much to gain from more specific advising structures.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in UNG over the next 72 hours.