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Where Does UNG Go From Here?

|Includes:The United States Natural Gas ETF, LP (UNG)

The United States Natural Gas Fund (NYSEARCA:UNG) is an ETF that tracks the front month natural gas futures contract. That is, until it sells that contract to roll over to the next month's contract. This happens according to a schedule published on UNG's web site and usually happens in the middle of each month.

In between the rolls, UNG tracks the front month natural gas futures contract PRECISELY. Due to the effect of serious contango over the past four years, UNG suffers losses as a result of contango each month. Of course, these losses are in addition to the losses that natural gas has experienced since 2008.

Everyone believes that the price of natural gas is simply the result of supply and demand in the marketplace. I heartily disagree. Yesterday, the average spot price at Henry Hub was $2.2682. A month ago, it was $1.99. Have the supply/demand metrics changed so much in a month to account for this large price swing? No.

Open interest in the July futures contract was 234,831 as of yesterday. This represents 2,348 Trillion BTUs of energy (234,841 x 10,000MM BTUs) or approximately 2.4 Trillion cubic feet (1000 cubic feet = 1 MM BTUs approximately). Monthly gas consumption is approximately 2.1 Tcf per the latest EIA Short Term Energy Outlook. That the open interest exceeds monthly consumption indicates that the market is dominated by speculation.

In a perfect market, the price of goods or services is determined by the intersection of supply and demand. However, the natural gas market is anything but perfect. Think about it. Why is the near month futures price of natural gas 55 cents higher than it was just a month ago? Are consumers of natural gas using that much more gas today than they were in April? No. Are producers of natural gas that much less willing to sell natural gas this month than they were last month? No. In the short term, both supply and demand are relatively inelastic. To reduce supply in the short term, you have to either cap a well or reduce the output of the well-something producers are loathe to do for various reasons. You cannot stop adding to the supply otherwise. In the short term, consumers do not change their usage habits that dramatically (in the absence of severe weather).

The price of natural gas (and thus UNG) is determined by speculators, just as the price of oil is. For almost four years, those that dominate the futures markets (the banks) made money hand over fist shorting natural gas. They took advantage of the CFTC's unwillingness to enforce position limit rules to flood the market with supply, driving prices down inexorably. Profits at the money center banks for their commodity desks soared. Producers were helpless to do anything about it and consumers (utilities) had no problem with cheap gas.

However, the speculators drove the price down so low that producers could no longer produce gas profitably and are shutting in wells and foregoing E&P investments in new wells. As a result of the declining forward futures price strip, producers could no longer hedge at a price greater than their costs to produce. At the same time, utilities were increasing their energy mix percentage of natural gas and buying futures aggressively to lock in low prices for months to come.

An inflection point finally hit. Consumption has skyrocketed and production is finally starting to abate. Today's price does not reflect today's supply demand balance (or imbalance). It reflects that sooner rather than later, there will be no gas available for sale at $2 and sooner rather than later, the price of natural gas will exceed $3/MMBTU.

Buyers increase their purchases, fearing future price increases and increasing demand at a time when producers can no longer rapidly increase supply.

In a world where there is such inflection, price changes take place rapidly. Prices for near term supply increase rapidly and future month prices do not rise as quickly. The result: less steep contango and even backwardation.

In any market, the key is to recognize an inflection point and act accordingly. I believe we have seen that inflection point.

Later this week, I'll post how short interest has added fuel to the fire of this inflection in the natural gas market.

Disclosure: I am long UNG.

Stocks: UNG