Natural Gas: Polar Vortex Split And Weather Models Converging On Cold Likely To Push Prices Higher

About: The United States Natural Gas ETF, LP (UNG), UGAZ, DGAZ, BOIL, KOLD, UNL, DCNG, GAZB
by: Andrei Evbuoma

Natural gas rallies with moderate cold in the near term (Jan. 9-14).

Weather pattern turns bearish (mild) for much of the U.S. in the medium range (Jan. 15-20).

Big cold risks late January into February offer great potential to the upside for bull speculators in UNG, UGAZ, and BOIL.

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Investment Thesis

A major cold pattern change coming late January into February offers a strong catalyst for the bulls and long positions in United States Natural Gas Fund (UNG), VelocityShares 3x Long Natural Gas ETN (UGAZ), and ProShares Ultra Bloomberg Natural Gas ETF (BOIL). Hence, the risk/reward does not favor the bears and those wanting to short the already deeply sold commodity.

Time To Go Long - Winter Is Not Over

Over the past couple of months, both the bull and the bear investor have had their moments of feasting. Back in November, it was the bulls who enjoyed a sharp rally of up to near $40.00 and natural gas contract futures near $5.00, as cold weather was priced in mid-month. Then as we got into the month of December, the bears feasted with heavy selling and natural gas prices falling to around 40%, basically erasing all of November's rally as a return to warmer-than-normal weather across the key consumption regions were being priced in. (Figure 1 below is an UNG chart showing the price trends of natural gas since November.)

Figure 1: Major milestones and price trends of natural gas (UNG) since November.

Source: Seeking Alpha

That leads us here, in early January, where natural gas is undervalued and/or an oversold commodity that looks attractive to buy and/or poised for a bounce back. So investors - both bulls and bears - are wondering, where do we go from here? From a technical standpoint, the argument can be made for the bulls based off what was just mentioned. However, we'll focus on the fundamentals because that's what really drives the commodity. Before getting into the fundamentals, though, I want to point out a few facts.

First, natural gas is a highly volatile commodity. Information such as weather and the EIA's weekly storage reports are key examples that can drive natural gas prices, supply, and demand. Investors like to follow the UNG. This is an exchange-traded fund (ETF) that tracks the movement of prices of natural gas. There are some exchange-traded products (ETPs) that track the movement of the underlying asset (UNG) and also give investors leveraged or inverse exposure to natural gas. There are a few I will mention. The first is the BOIL. This leveraged ETF aims to provide 2x leveraged exposure to natural gas. Its inverse is the ProShares UltraShort Bloomberg Natural Gas (KOLD), which takes the 2x inverse position. Another one is the UGAZ, also a leveraged ETF that returns three times the daily return of the UNG. UGAZ has an inverse called the VelocityShares 3x Inverse Long Natural Gas ETN (DGAZ), which takes the short position. So BOIL and UGAZ can be looked upon as the bulls' leveraged ETFs, taking the long position, while DGAZ and KOLD can be looked upon as the bears' leveraged ETFs, taking the short position. Given the high volatility of natural gas, these leveraged ETFs are high-risk/high-reward items that should only be used for short periods due to leverage-decay risk. In general, leveraged ETFs are safer/lower risk when volatility is low.

So with this background information covered, we can now discuss where we are and where we are going. Lately, both the bulls and the bears have been in a bit of a standoff. After peaking back in mid-November, natural gas volatility has dropped to its lowest levels since early December, with the commodity recently trading very narrowly between the range of $2.94 and $3.04. This comes as investors look for better direction and clarity with the weather pattern.

In the near term, moderately colder weather has moved in over the eastern half of the country. The cold is more of a modified cold (Canadian origin rather than Arctic) and transient (lasting just three to four days). That said, investors should expect natural gas to continue its rally in the short term. In fact, front-end natural gas contracts should push upwards to over $3.00. (Figure 2 below is a depiction from the ECMWF Ensemble of a warm West US vs. cold East US alignment for Week 1.)

Figure 2: 12z EPS Week 1 (Jan.9-14) averaged 850 mb temperature anomalies.

Figure 4: 12z EPS Week 1 (Jan.9-14) averaged 850 mb temperature anomalies

Source: WeatherBell

In the medium range (Jan. 15-20), the pattern will return to bearish with mild weather encompassing much of the country as the upper-level flow pattern becomes semi-zonal. All of this taken into consideration should keep prices hovering around the $3.00 mark over the next seven days or so with bouts of both gains and losses. That said, the window is shrinking and the risk is quickly increasing for bearish speculators (the short trade) in DGAZ and KOLD. (Figure 3 below gives a depiction from the GEFS of widespread warmth covering much of the country next week.)

Figure 3: 06z GEFS (Jan.15-20) averaged 850 mb temperature anomalies.

Source: WeatherBell

Arctic, wintry weather coming late January offers a strong, compelling catalyst for the bulls

As we turn our attention to around Jan. 20, investors should shift, if not have already done so, towards the long positions of UGAZ and BOIL with the prospects of colder-than-normal temperatures coming in. For days now, forecast models have consistently been advertising a major weather pattern cold shift across the central and eastern U.S. This cold will come with Arctic values, and according to the upper-level maps and longer-range computer models (namely ECMWF Weeklies and CFSv2), the pattern has the appearance of a block pattern - meaning that there's potential for this cold to be sustained for weeks. The pattern change should take place in the Jan. 20-22 time frame. So far, the longer-range models have this cold pattern continuing up until mid-February. With this cold pattern shift, we're easily talking the coldest air mass that we've had thus far this winter season (Arctic air mass) with strong heating demand, bullish inventory withdrawals, and very high potential upside for UNG and the leveraged ETFs UGAZ and BOIL. (Figures 4 and 5 depict the CFSv2 and ECMWF Weeklies' Week 2 and Week 3 Outlook, respectively. Both indicate a major COLD pattern shift over the eastern half of the country in the Jan. 21-28 time frame.)

Figure 4: 06z CFSv2 Model 500 mb Heights depicting a colder change to the pattern Jan. 17-24 timeframe (Warm West US vs. Cold East US). GFS, GEFS, GEM amongst models that show similar pattern.

Source: TropicalTidbits

Figure 5: 0Z Jan. 7 ECMWF Weeklies 500 mb Heights depicting a colder change to the pattern (Week 3) Jan. 21-28 time frame (Warm West US vs. Cold East US). GFS, GEFS, GEM amongst models that show similar pattern.

Figure 5: 0Z Jan. 7 ECMWF Weeklies 500 mb Heights depicting a colder change to the pattern (Week 3) Jan. 21-28 timeframe (Warm West US vs. Cold East US). GFS, GEFS, GEM amongst models that show similar pattern

Source: WeatherBell

It's also worth mentioning the polar vortex. We've seen a Sudden Stratospheric Warming event take place already in late December. The polar vortex did not recover from that and as a result, has split into three separate vortices. This split has been showing up in the models for early January with a large chunk centered over the western/northern parts of Europe, another chunk over the U.S., and a smaller piece over the Pacific Ocean. Strong warming is also taking place in the polar caps. The key for investors is that this is not a forecast. It's already happened and it is being observed in the weather models. It usually takes a couple of weeks or so of seeing this propagate into the troposphere before impacts will be felt here in the mid-latitudes at the surface.

This, coupled with the weather models signaling cold, means that winter is not over - which fundamentally gives great upside potential for speculators in UNG, UGAZ, and BOIL. As things stand now, I'm giving a price target of $3.50 should this Arctic outbreak verify. (Figure 6 below shows this Polar Vortex split from January 6, 2019, depicted on the 06z GFS.)

Figure 6: Polar Vortex Split.

Figure 6: Polar Vortex Split

Source: InstantWeatherMaps

Currently, we have a weak El Niño in place. This has been a dominant player in our weather pattern, especially in December and the early parts of January. This El Niño, however, is not the typical El Niño we've had over the last few winters, neither in strength nor type. In a classic (typical) El Niño, Sea Surface Temperatures (SSTs) are predominantly warm over the eastern equatorial Pacific. We have a Modoki (central Pacific based) El Niño where SSTs are warm mainly over the central Pacific with bookend cooler waters over the eastern and western equatorial Pacific. According to analogs, this offers more of a colder risk for the U.S. as compared with the typical El Niño, as this type of El Niño (Modoki) has tendencies to at times send the jet stream into disarray (especially in mid- to late winter).

With that said, El Niño still has to be taken into consideration. However, the polar vortex split and the colder consistencies in the forecast models for late January into February can't be ignored. Given what we know about this year's El Niño (weaker, Modoki type) as compared with previous years, this year comes with a greater risk for cold outbreaks in the U.S.

Final Trading Thoughts - Gas Prices Expected to Rise, Storage Deficit Gap Expected To Widen

In summary, natural gas prices should hover around the $3.00 mark over the next week or so with bouts of both gains and losses. Upside potential then shifts towards UNG, UGAZ, and BOIL. Should the models verify, as we move further along in the month of January, natural gas contracts should go north of $3.00 upwards to $3.50 with UNG going above $25.00 and upwards to $30.00. The intensity and duration of the cold will be key. Should the cold pattern lock in (sustained Arctic air), prices will go higher than $3.50 and $30.00. For now, investors should plan to go long targeting $30.00 UNG or $3.50 front-end natural gas contract futures.

Regarding storage, the Energy Information Administration (EIA) on Thursday (Jan. 10, 2019) released its weekly natural gas storage report for the week of Dec. 29-Jan. 4. The report came in bullish with a net draw of 91 Bcf for that week, ultimately bringing storage levels down to 2,614 Bcf. That exceeded the consensus expectation of a 69 Bcf decrease. Even though the -91 Bcf was a bullish number, it was still much smaller than the five-year average of -182 Bcf and last year's number of -359 Bcf. This, as a result, helped to narrow the storage gap between this year's levels (which still remains at a five-year low) and the five-year average (Figures 7 and 8 below are both depictions of yesterday's EIA's natural gas storage report for the week of Dec. 29-Jan. 4.)

Figure 7: Thursday's (Jan. 10, 2019) EIA Natural Gas Storage Report (Table Format) for week of Dec. 29-Jan. 4, 2019.

Figure 7: Today

Source: EIA

Figure 8: Thursday's (Jan. 10, 2019) EIA Natural Gas Storage Report (Graph Format) for week of Dec. 29-Jan. 4, 2019.

Figure 7: Today

Source: EIA

There could be some additional slight narrowing over the next week or so. However, the gap between this year and the five-year average will widen, more placing additional pressure on reserves once the cold weather starts coming in later in the month.

Despite the bullish storage report, it did not have much of an impact on trading Thursday as investors/traders seemed more focused on temperature trends. It was similar to what happened after last week's report release from Friday, Jan. 4 where natural gas rallied 3% on expectations for cooler weather coming in despite the bearish EIA storage data. This type of reaction would further lend support to UGAZ and BOIL.

Stay Tuned For More Updates!

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