Over the past year, investors in the United States 12 Month Natural Gas Fund (NYSEARCA:UNL) have seen shares basically trade sideways, frustrating bulls and bears alike. While returns in this ETF have been lackluster this year, I believe that UNL represents a very strong ETF based on its methodology as well us unfolding natural gas dynamics. Specifically, I believe that over the next few months, shares of UNL are likely to shine as natural gas sees fundamental strength.
Prior to discussing natural gas markets, we need to do a fairly in-depth analysis regarding what exactly UNL is and why it is one of the better gas investment options out there. What is particularly noteworthy to me regarding the instrument is that it is largely overlooked by the gas ETP trading community in that its AUM significantly lags most other options, as seen in the following table from ETF.com.
The reason why I am struck by this disparity in AUM largely boils down to the pure numbers of an investment in UNL as compared to alternatives. What I mean by this is that two of the ETFs on this list are provided by USCF Investments (UNG and UNL), and yet, the one with the worst performance is currently commanding over 100 times more assets.
To graphically see this, here is the past year of returns in UNL compared to those of the more popular UNG.
As you can see, UNL (blue line) has outperformed the return of UNG (red line) by nearly 30% throughout the recent downturn. And despite this fairly strong outperformance, there are still substantially fewer dollars invested in this ETF. So, what is driving this outperformance? Let’s dive in and find out.
To understand the difference in performance between UNL and UNG, we need to examine the two different methodologies respectively. UNG’s methodology is fairly straightforward: it holds the front-month natural gas futures contract, and then, two weeks before expiry, it shifts exposure into the second-month contract. Its table of holdings can be seen below representing this simple methodology at work.
UNL, however, is not as straightforward. As can be seen in its methodology, the fund holds exposure across the front 12 months of futures contracts. At this point in the trading month, this means its holdings are as follows.
Okay, so the fund holds 12 months of futures... why does this matter? Good question, glad you asked. The reason why it is important to note the difference of holdings as it relates to returns is due to the roll yield factors associated with maintain exposure in the futures market. As we’ll discuss in the next few paragraphs, the key win for UNL (and why it strongly outperforms through time) is that since the fund is able to hold diversified exposure with an average expiry several months away from the prompt, the impact of roll yield is much less than that for UNG, which is confined strictly to the front two contracts.
The last paragraph was probably a little dense, so let’s take it piece by piece. In financial markets, there’s a tendency for futures prices to approach spot prices through time. This tendency is called “roll yield”.
The underlying implication of roll yield is fairly straightforward: whatever the difference in price between futures contracts and the spot price is will be directly correlated with the impact of this convergence upon returns. What this essentially means is that if futures prices are above spot prices, roll yield will be negative, because as time progresses, futures prices will be converging towards the spot price by declining in value.
Okay, so that’s the basic theory, but what does the data actually show? In the following chart, I have taken the average differential between a few different natural gas price benchmarks by trade date over the last 10 years of data.
There’s a lot of data behind this chart, and it conveys a few different pieces of information, so let’s spend some time digging into it. First off, the data is divided by trade date, which is essentially the number of days since a contract became prompt. For example, the first day after the expiry of natural gas futures would be the first trade date shown above.
The blue line in the chart above (M1 to Spot) shows the difference between the front-month futures contract and the spot physical price of natural gas at the Henry Hub - since it is positive, it means that on average, the front-month futures contract is above the spot price (also known as contango).
Physical spot pricing for natural gas can be notoriously volatile, which explains the bumps in the chart, but there is a clear overall relationship: the difference between the spot price and the front-month futures contract narrows throughout a typical month. On average, for the past decade, we have seen the front-month futures contract start a month about 1% above the spot price of natural gas, and throughout the course of the month, it declines in relation to the spot price by about this same amount (in financial lingo, this is “futures converging to spot”).
The above relationship is very interesting to hone in on because it essentially shows that, on average, a fund which starts a trade month holding the front contract will see a degree of losses as the futures prices converge towards the spot price of natural gas.
If you recall, UNG’s methodology is holding exposure in this front-month contract and then shifting it to the second-month contract about two weeks prior to expiry. This tangibly means that UNG is basically long the blue line (M1 to Spot) until it starts rolling into the red line (M2 to M1) around trade date 10-12 or so. Over this time period, the front contract differential to spot declines by about 1% in an average month.
You can annualize this figure to get a rough approximation as per the losses seen from roll yield. Based on this simple convergence analysis above, it would suggest that UNG loses a little over 1% per month due to roll yield (or around 12% per year) based on the historical convergence between futures and spot.
It’s really important to drive this point home: this simple analysis of how futures behave shows that you need natural gas prices to increase by 12% simply to break even in most years in an investment in UNG, due simply to roll yield.
Now let’s examine UNL. The fund holds this front contract as well, but it also holds the next 11 so that it has exposure across the front 12 months. This is very beneficial for holders in that much of the roll yield losses are removed due to the fact that futures rolling towards spot tends to be most dramatic at the front of the curve.
To understand what this means, look back at the prior chart. If you look carefully, there is a marked difference between the lines of shorter duration and those of longer duration. For example, while the M1 to Spot line decreases by about 1% over the course of the month, the M4 to M1 line is actually flat to slightly up during the month.
What the above chart essentially shows is that as you broaden your exposure to later points out along the futures curve, the impact of roll yield is diminished, since these later contracts don’t converge towards the spot price to the same magnitude as the front of the curve.
This is why UNL is a clear winner versus UNG when it comes to trading natural gas in these current markets: futures converging towards spot in a contango market takes a strong toll out of front-month holders, whereas holdings out along the curve at later points don’t decline to nearly the same magnitude (or even at all).
With UNL, we have a better chance of seeing our returns more directly linked to the price of natural gas, since roll yield doesn’t impact returns to the same degree as funds like UNG. With this established, let’s turn our attention to natural gas fundamentals to understand what’s driving gas at this time.
Let’s start with natural gas production. In the below chart, there’s a clear trend of growing production for the past few years.
While this trend has been firmly established for several years, there is a substantial disruptor in the works which is decimating production as we speak: the dropping rig count.
Over the past few weeks, we have seen one of the fastest contractions in the number of rigs drilling for natural gas ever seen. This decline in drilling is important to note because it signals that, within a very short amount of time, we are going to see natural gas production weaken.
The timing of this is very important to note, because we are entering a time period in which natural gas demand typically increases due to electric power demand. Again, the monthly data shown is just through February due to the lagged EIA release times, so look at the May-June time frame to see the current seasonal pattern we are in.
What this essentially means is that supply is being shredded as the rig count has fallen sharply due to weak energy prices, while at the same time, demand is set to rise over the next few months and through the summer.
This contraction in supply, coupled with an increase in demand, ultimately will lead to weaker inventories as natural gas stocks are drawn down. This is important to note and monitor, because there is a direct correlation between how stocks change on a seasonal basis and the price of natural gas.
What the above chart shows is that as natural gas declines on a year-over-year basis, the price of natural gas increases to a similar magnitude (within some degree of variability). The key takeaway point here is that we are currently sitting at an inflection point in fundamental data in which weakening supply will be met by strengthening demand, which will likely lead to a contraction in inventories on a year-over-year basis. This contraction in stocks will likely lead to an increase in price and profits for holders of UNL, making it a great time to buy the ETF.
UNL is a superior alternative to its sister fund UNG due to its diversified rolling methodology. Natural gas supply is set to weaken substantially as the rig count has collapsed. Weak natural gas supplies, coupled with rising seasonal demand, will likely lead to higher gas prices in the near future.
This article was written by
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.