Natural Gas, like most commodities, trades on the futures exchange and can be purchased for immediate delivery or for future delivery which can extend for many subsequent months. The normal state is for future months prices to be greater than earlier months, leading to a positively sloped curve as shown in the chart above on the left. This state of elevated prices for future months is known as "contango". Its opposite, "backwardation", is the rarer condition where front month prices exceed subsequent month prices, and might exist about 20% of the time.
Contango is a significant issue for natural gas investors, as it can be a significant cost. The cost is incurred when one "rolls" from the front month contract to the subsequent month contract at a higher price. One rolls contracts in order to maintain their position and continue to hold natural gas as the current month expires. The United States Natural Gas Fund (NYSEARCA:UNG) is a popular ETF which invests in natural gas futures and rolls front month contracts to subsequent month contracts in order to maintain its position. This contango effect will change depending upon traders' perceptions about the available supply of natural gas. While there is no specific formula for calculating contango, the amount of contango generally increases in times of high perceived supply and will reduce or become negative (backwardation) in times of low perceived supply.
Breaking from its normal contango, natural gas went into backwardation during much of July this year, as injections of gas into storage diminished while low prices took away incentives for drilling new wells and for increasing production. However, in August that began to change and contango crept back into the futures structure. Just this week, contango has jumped substantially. Contango, as this article is being written, is about $0.16 which works out to an annualized cost of over 97%, as compared to only 14% annualized cost the prior week. This means that roll cost for UNG will once again become a significant burden and could therefore cause UNG to underperform the spot market over the long term.
What can investors do about this situation? If an investor is bullish about natural gas, several investment positions can be considered. One is to own UNG for relatively short durations, say up to six weeks, to capture what you believe will be rallies in an historically volatile commodity. Even when in contango, UNG can be a good trading vehicle for those with the ability and predisposition to "buy the dips and sell the rips". Or, one can move out of UNG and into one or more of the gas-dominated producer equities. The equities have generally underperformed the commodity since the rally began in April; at some point they may start to play catch-up as discussed in this article. Names such as Encana (NYSE:ECA), Chesapeake (NYSE:CHK), Anadarko (NASDAQ:ADP), Exco (NYSE:XCO), and Ultra Petroleum (NYSE:UPL) should benefit from rising gas prices. Or, if you want a diversified, unmanaged basket of gas equities there is the First Trust Revere Natural Gas ETF (NYSEARCA:FCG). Leverage can also be obtained if desired through the Direxion Natural Gas Related 3X Bull Fund (NYSEARCA:GASL) which seeks to provide results that are three times the Revere ISM Natural Gas Index.
Finally, there is an investment that deals directly with the contango problem, and actually benefits from negative roll cost: the UBS E-tracs Natural Gas Contango ETN (NYSEARCA:GASZ). The Fund invests in various futures that have the effect of shorting front months while going long midterm natural gas futures. If you believe that contango may stay at these high levels for a period of time and you want to be a long term holder of natural gas, this would be a good choice. However, this is a relatively new fund with only $12 million in assets and average daily volume of 18,339 shares, as compared to UNG with assets of over $1 billion and average daily trading of over 12 million shares.
Contango is a significant aspect of natural gas investing. To check and see how much contango exists in the natural gas curve, interested readers can get updates at the CBOE website which quotes the price for various gas futures at Henry Hub.
Disclosure: I am long UNG, XCO. 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.