- UGAZ has taken a tumble this year as poor gas demand has eroded the price of natural gas.
- Natural gas fundamentals are changing, with a hot summer coupled with declining production expected to push prices higher.
- UGAZ is heavily exposed to roll yield losses, so a strategic timing of a trade in the ETN makes a good deal of sense.
Over the past few months, we have witnessed the price of the VelocityShares 3x Long Natural Gas ETN (UGAZ) shed value as gas has continued to trade lower.
While this year has been difficult, I believe that we are nearing a turning point in the fundamentals. Specifically, I believe that over the coming months, we will see UGAZ reverse its past few months of declines with a strong rally in natural gas.
Natural Gas Fundamentals
To start this piece off, let’s run through the natural gas supply and demand balance to assess what variables have been impacting the market as well as form a hypothesis of where prices are likely headed.
From a broad perspective, we have generally seen a good degree of weakness in the balance in the first part of this year as supply remained strong while consumption has collapsed.
These variables have ultimately led to inventories growing against the 5-year average throughout this year.
As you can see in the chart above, the key problem for shareholders of UGAZ is that when inventories climb versus benchmarks like the 5-year average, prices tend to fall.
However, while this has been a difficult year in terms of supply and demand, I believe that we have two major fundamental shifts coming over the next few months which will dramatically change the balance to the bullish side. First off, we are expected to experience a hot summer.
What the above chart shows is that during summer, which is the peak time for natural gas power burn, we will see abnormally high temperatures across every major demand region. Granted, this is a weather forecast and therefore subject to revision – but if we see anything even similar to this actually materialize, we can expect to see record burn of natural gas demand for the summer period.
It is import to frame up this particular comment on gas demand in terms of history. Historically speaking, natural gas has progressively become a greater share of the baseline generation fleet as coal has been supplanted by gas in almost every year for the past two decades.
As you can see from a 5-year average perspective, the amount of natural gas demanded by the power sector continues to grow with this year seeing record seasonal demand and last year setting the top of the 5-year average.
So, when it comes to power demand (which drives the summer demand fluctuations of natural gas), we are likely to see a strong pull from the sector this year.
And the other bullish factor impacting the balance is this: production is collapsing. As you can see in the following chart, the recent price decline has essentially reached the point where the rig count is in free-fall.
The important thing to note about the rig count is that it is generally only corrected through higher prices. For example, during 2015-2016, we witnessed a similar decline in the price of natural gas, and after several months of weak prices, the rig count ultimately dropped to a point of unsustainable levels of production. This low level of drilling activity was only arrested after price had risen around 50% and wells were economic once again.
At present, we are seeing this relationship of collapsing production at work across every major gas producing basin.
As you can see in the data from the STEO, the EIA is expecting gas production to drop by over 10% this year as a result of the low prices.
What is noteworthy here is that the EIA is also calling for the price of natural gas to rally by around 85% between now and December. The EIA is a generally impartial organization with no market position, so this can serve as a check on our analysis.
My view is that the strong power burn this summer coupled with an ongoing collapse in production will result in above-average tightness in the balance for natural gas through year-end. I believe that natural gas will rise strongly as a result and that shares of UGAZ stand to benefit.
Prior to executing a trade in UGAZ, we need to take a pause to actually understand how exactly UGAZ works. Put simply, UGAZ is an ETN which tracks the front-month Henry Hub NYMEX contract, and then a few days before expiry, it will shift this exposure into the second month futures contract (after which the front month expires and the second month becomes the front month).
This process is fairly simple, straightforward, and generally uniform across ETPs which track futures curves. What is not straightforward, however, is the gains or losses that occur in a typical month from something called “roll yield”.
Here’s the basic problem that constitutes roll yield: futures converge to the spot price. What this basically means is that over time you will see the difference in price between the spot price of a commodity and the futures price of the commodity converge to be the same price. The reason for this is that after the expiry of the front month futures contract, the position actually becomes the spot commodity.
So, here’s the problem and where things get slightly complicated. There is typically a difference between the spot price of a commodity and the futures prices of the commodity. In the case of natural gas, futures contracts have historically been above the spot price about 82% of the time since 1995. In other words, gas prices are almost always higher along the futures curve than the spot price of the commodity.
This difference between the spot and the futures contract has resulted in substantial losses for shareholders in gas-linked ETPs through time. The reason for this is that since gas traders are holding futures contracts which are above the spot price and this difference is narrowing through time, investors are losing money from the convergence towards spot.
These losses are hard to notice on short time periods, but become obvious the longer you hold the ETP. As I calculate it, an unleveraged position in the front month futures contract has lost around 1-1.5% per month over the past decade. UGAZ is a 3x leveraged ETP, so you could say that in a typical month, UGAZ has historically lost about 3-4.5% per month to roll yield.
This is an important figure to keep in mind in that it essentially represents a hurdle which UGAZ will need to overcome to deliver profit to investors. The simple math suggests that you need the price of natural gas to rise by over 12% or so during a year for you to break even on a trade which holds exposure in the front month futures contract. Given that the EIA is currently calling for an 85% rally in the price of gas through year-end, I believe that this hurdle is sufficiently met – at least for this year.
It is my belief that gas prices stand to rally strongly throughout the rest of the year. If you are interested in taking this trade, I suggest managing risk appropriately because this is a leveraged trade on a volatile commodity. If the EIA is right, then UGAZ could deliver over 200% by year-end. But along the way, there will certainly be bumps and fluctuations in this number, so I suggest only a small allocation of capital to the ETN.
As an execution method, I would also suggest that investors wait for price to start moving higher before executing. The reason for this is that UGAZ is losing money to roll yield on an ongoing basis which means that it makes a lot of sense to wait for prices to actually start moving in the expected direction before allocating capital. If you’re looking for a simple execution method, a breakout of 1-month highs as an initial entry point will likely allow you to capture the bulk of the coming trend while protecting you from ongoing losses from roll yield.
UGAZ has taken a tumble this year as poor gas demand has eroded the price of natural gas. Natural gas fundamentals are changing, with a hot summer coupled with declining production expected to push prices higher. UGAZ is heavily exposed to roll yield losses, so a strategic timing of a trade in the ETN makes a good deal of sense.
This article was written by
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