Why Natural Gas Prices Will Rebound

Includes: FCG, UNG
by: Daniel Lauchheimer

As I am sure many readers know, the market has set natural gas on a collision course with zero for some time now. The bears, looking through their crystal ball, will have you believe that we will eventually get overrun, or better yet we have already gotten overrun, with a wave of natural gas produced from shale sources, which will drive down prices. In this article I will examine the basic fundamentals of supply and demand, and see, looking through this lens if that argument really holds water.

Below you will find a table with the basic supply and demand figures comparing the previous high - July 2008 - with July 2011. The reason for using July 2011, as opposed to say, December 2011, or January 2012, because besides for the fact that the EIA hasn't published complete data for those periods yet, we must compare figures from identical or at least similar periods, as the price of natural gas varies seasonally - higher in the winter months when used for heating, and lower in the summer months when not used for heating.

Figures (Period)

Underground Storage Volume (MMcf) - Supply

US Natural Gas Total Consumption

(MMcf) -- Demand

July 2008



July 2011



As you can see from this table, while supply has increased between these two periods 4.71%, demand has also increased, at a much faster clip of 9.14%, if anything supply has not kept up with demand! Therefore, I don't understand, why if supply and demnand fundamentals have not changed over this period of time, has the price of natural gas decreased so dramatically.

NB - demand for natural gas fired electricity have driven a majority of the growth. In July 2008 electric customers consumed 782,039 MMcf, but in July 2011 they consumed 942,201 MMcf - a 20% increase.

I suppose I should include some explanation from those who disagree with this theory, but I have yet to hear a reasonable one. Everyone just screams, "shale, shale, shale," but frankly that cry of fear seems to ring quite hollow. If shale gas has flooded the market, where is it? The numbers don't seem to support the story, and as I pointed out, even though supply has increased modestly, demand has increased even more.

If you buy this story I am telling, then you have a few options in the ETF market. I think the ETF market allows investors to play this story more safely because buying vanilla futures locks you into a specific time when natural gas will have to increase if you want to make money. And considering prices don't seem to follow any logical order, trying to predict exactly when prices will peak could prove quite tricky. Therefore, buying an ETF allows you to take a long term positive view of the market and decreases the significant downside risk.

In the ETF market you should consider United State Natural Gas Fund (NYSEARCA:UNG), an ETF which basically tracks the market - percentage wise. However, UNG suffers from a very basic problem. The way it executes its strategy of following the percentage changes in the market, by buying the forward (next month's) contract. Therefore, if you buy UNG today, then you will essentially own the forward contract for March, which as of 2/19/2012 stood at $2.60/MMBtu.

If you hold onto UNG through February and into March, then you will own the April contract. UNG accomplishes this by selling the March Contract (for $2.60 using current prices), and then uses the proceeds to buy the April contract. Assuming the April contract costs $2.70 then you will have to pay 10 cents extra to own the April contract. If the prices continue to go up, then your investment will continue to decrease. UNG avoids this by using a fairly complex hedging scheme, which avoids this problem somewhat (although in the long run, if natural gas prices increase, say, 100% UNG will not increase that much, but probably less), allowing you to effectively long natural gas.

Investors who believe as I do can also buy First Trust ISE-Revere Natural Gas Index Fund (NYSEARCA:FCG). FCG follows an index of natural gas companies that derive a majority of the revenue from the exploration and production of natural gas.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.