- Natural gas fundamentals are at a key inflection point as demand is rising while production is collapsing.
- UNL has strongly outperformed its sister fund, UNG, due to broad exposure across the curve.
- UNL is likely going to continue performing as backwardation is priced into the gas markets.
It is my belief that natural gas fundamentals are poised to switch based on both supply and demand factors in the immediate future. Specifically, I believe that natural gas will rise throughout the rest of this year and that UNL represents a strong way to play the move.
Natural Gas Fundamentals
From a fundamental standpoint, this year has been difficult for the gas bulls. We started the year off with very poor total consumption due to a mild winter.
And continued the trend of poor demand through the past few weeks as the coronavirus has slowed industrial demand for the commodity.
If that weren’t enough, natural gas supply continued to rise (through the first quarter at least) as production marched higher.
This combination of fundamentals resulted in weekly builds which were above-normal throughout most of this year.
And these builds ultimately pressured gas prices lower.
When you examine the actual pattern of inventory builds, the case has been even more bearish as key demand centers like the East and South-Central have seen inventories pushing towards the top of the 5-year range.
Without a doubt, this has been one of the most bearish years on record for natural gas traders, and investors in UNL have felt the impact as seen by substantial volatility in the ETF.
However, if you’ve been watching short-term fundamentals, you’ve likely noticed that we are reaching an inflection point. That is, prices have simply been too low for too long and producers are culling production.
Over the last year, about 60% of the total gas rig count has been pulled from the field. There is a lag between a decline in rig count and an actual decline in production, but the EIA is estimating that total gas production will decline by over 10% between now and the end of the year.
Not only is production expected to immediately decline due to the drop in rig count, but also we are expected to see a strong summer power burn demand due to hot weather.
The key demand centers for natural gas include the East Coast, Gulf Coast, and West Coast. These regions are expected to see abnormal temperature during the time of the year in which air conditioning demand is the greatest. In other words, we are setting up for a very strong demand period this summer. When you factor this with the expected decline in natural gas production, we can likely expect prices to rise in the near future.
Now that we’ve quickly stepped through the major gas fundamentals, let’s focus specifically on UNL. UNL is a very interesting ETF which I believe is highly underrated in the natural gas space.
To start off from a very high level, here is the current year-to-date performance of UNL versus its sister fund UNG.
As you can see, UNL has outperformed UNG by around 26% this year. Simply said, this is outstanding performance considering that the prompt price of natural gas has been catering this year. So what is happening to drive this strength?
Put simply, UNL is an ETF which is cognizant of the big elephant in the room when it comes to commodity ETFs: roll yield. Roll yield is often a very confusing topic, but I’ll try to explain it as simply as possible in the following paragraphs.
When you invest in an ETF like UNL or UNG, the fund is essentially pooling and investing your money in futures contracts. When it comes to the natural gas markets, futures prices tend to be in a state called “contango” – or they increase in value as you look out along the curve. Here is the current forward curve which shows the markets in contango in the first few months.
The problem of roll yield basically boils down to this: futures prices ultimately converge to the spot price. What this means is that if you go out and look at the spot price of natural gas (the price you could pay to buy the physical gas right now in the market), it is cheaper than the front-month futures contract. However, if you fast forward a few weeks to when the front-month futures contract expires and the physical delivery process starts, this difference in price between the spot market and this futures contract will be around zero dollars because this futures contract becomes the spot commodity at expiry (as individuals make or take delivery of physical gas on the futures contracts they hold into expiry).
Over the past 10 years, natural gas markets have seen the front-month futures contract in contango about 83% of the time when compared to the spot price of gas. Said another way, futures contracts in the natural gas markets are almost always priced higher than the spot price.
The problem for a gas ETF is this: it is holding futures contracts which are priced above the spot price and during a normal month, the front-month futures contract declines in value and “rolls down” into the spot price (because the futures contract becomes the spot commodity). In other words, if you’re holding the front-month gas futures contract, the return you earn will actually be subject to two things on any given day – 1) how much the general price of gas moved and 2) how much the difference between spot and front-month futures shrank during that day.
If you carefully think through the above relationship, it has implications for your returns depending on where along the futures curve you are actually holding exposure. For example, if you are holding the front-month contract, you will experience the roll-down most heavily as you are holding the futures contract which becomes spot within a month. However, if you are holding exposure, say, 12 months out, this roll-down towards spot will have very little impact upon your holdings because the futures contracts you are holding do not become the spot commodity for about a year.
If you understand this relationship, you will likely immediately understand the appeal of UNL vs. UNG. While UNG is holding and rolling in just the front two futures contracts, UNL is holding exposure across 12 full months. To see this in force, here are the current holdings of the ETF.
This is why UNL has strongly outperformed UNG over the past few months. We have seen a heavily over-supplied physical gas market, so the contango structure has strengthened in the prompt.
This increase in the degree of contango in the curve basically means that the losses seen from roll yield in the front contract have strongly increased since the distance required for convergence between spot and futures has increased.
Ultimately, the key message here is this: UNL’s diversified holdings across the futures curve serve to substantially mitigate the impacts of roll yield since its exposure is held out across the curve. However, there is another key benefit in that as the market prices in long-term fundamentals, UNL benefits as well.
To understand what I mean, go back a few charts and look at the forward curve for natural gas. At present, the market is growing to realize that the balances are tight over the next few months and this is being priced into the curve. Specifically, it is being priced into late-2020 through 2021. You can tell this by the backwardation seen when a seasonal comparison is made.
The above chart shows the M1-M12 futures structure (for example, the data point for Dec-20 = Dec-20 – Dec-21). When the number is positive, this represents backwardation when compared to the next year’s figure (because that specific contract is higher than that same month in the next year). This type of chart basically strips out the seasonality embedded in the futures curve to understand what the market believes will happen to gas fundamentals in the future. As you can see, the market is pricing in heavy backwardation in 2021 as compared to 2022.
The reason why I say that long-term exposure is a benefit to UNL is that it is holding futures contracts all the way out into 2021 (since it has 12-month exposure). What this means is that UNL’s holders are benefiting from the market moving further into backwardation as market participants start to price in the bullish fundamental outlook. This is another one of the key reasons which UNL has strongly outperformed UNG: its exposure is so broad that it is enabled to capture broad fundamental shifts in the natural gas markets – shifts which UNG is simply unable to capture due to its narrow focus.
Going forward, I believe that the market will continue to price into backwardation in the coming months as gas inventories start to weaken against benchmarks like the 5-year average due to poor production and strong demand. I believe that UNL remains a superior method of trading this relationship in that it both reduces roll yield and its broad exposure allows it to catch trends as they price into the curve.
Natural gas fundamentals are at a key inflection point as demand is rising while production is collapsing. UNL has strongly outperformed its sister fund, UNG, due to broad exposure across the curve. UNL is likely going to continue performing as backwardation is priced into the gas markets.
This article was written by
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