UNG: Prepare For The Rally In Natural Gas

Summary

• The technical picture is starting to show bullish momentum in UNG.
• Economic demand for natural gas is recovering while production is declining – a classic recipe for higher prices.
• UNG is exposed to negative roll yield so investors could consider a tactical approach to entry and exit.

As can be seen in the following chart, the United States Natural Gas Fund (NYSEARCA:UNG) has been in for a turbulent year with shares continuing to shred value.

While these losses have been substantial, I believe that we are at an inflection point in the fundamental data. Specifically, I believe that both fundamental and technical data suggest that now is a good time to buy natural gas and that over the next few quarters will we see gas prices rally.

Natural Gas Markets

Let's start this piece off with a brief look at the technical picture. As you can see in the prior chart, natural gas has been in a downtrend for several months on the back of fairly bullish fundamentals. However, I believe that technically speaking, we are poised to see a switch in momentum as seen by the MACD turning over and showing positive momentum.

The MACD is a fairly simple indicator which measures momentum by calculating a few metrics based off of two moving averages. This indicator can be interpreted fairly straightforwardly in that when the bar chart is green, it means that momentum (as measure by moving averages) is positive and the converse is true when the bar chart is red.

As you can see in the chart above, we have just ended a period of bearish momentum and we have flipped into moderate (but growing) bullish momentum. While the overall trend has been down for some time, this at minimum suggests that the trend will pause or likely reverse. I believe that the odds favor a reversal into a bullish trend in that over the past month we have seen the market fail to sustain new lows. This tells me that the sustained heavy selling seen earlier this year is likely done for now and a fresh bullish trend may emerge from the data.

This said however, it is my opinion that we should ultimately base our trades around fundamental data. The reason for this is that while you can earn returns purely through technical analysis, I believe that a coupling of fundamentals with technical factors can make for the most holistic recommendations.

From a fundamental standpoint, natural gas inventories are finally starting to tighten against the 5-year average as seen by the week-over-week changes in stocks.

As you can see in the below chart, it's been a quite bearish year as inventories have almost continuously climbed against the 5-year average throughout the entire year.

Seen from another perspective, we have seen the surplus versus the 5-year average of stocks grow in almost every month since early 2019.

This ultimately has been a depressant upon price because of a simple economic relationship: as inventories grow versus benchmarks like the 5-year average or the figures from the prior year, prices tend to fall.

However, as seen in the chart of week-over-week changes, we are luckily starting to see inventories changing at the same pace of the 5-year average with a gradual weakness emerging over the last two weeks.

Here's what I believe is happening to drive this change. First off, we are seeing an increase in economic activity in that people are returning to work. We can directly measure this through crude runs.

Since individuals have largely been working from home or unable to return to work due to shelter-in-place measures, refining runs have been weak because the gasoline for driving simply hasn't been needed. However, as seen over the past two months, we are in the midst of a sustained recovery in refining demand as the economy reopens.

How this equates to natural gas demand is that as individuals are returning to offices and workplaces, there will be a greater pull upon natural gas for industrial demand as well as electric generation to power workplaces which were under-occupied previously.

The other factor to monitor here is the collapse in drilling activity.

There's a lag between a drop in rig count and a subsequent decline in production, however over time production will respond to the dramatic decline in active gas-drilling rigs. For example, in the EIA's latest STEO, it is expects natural gas production to decline for at least the next two years with declines accelerating through 2021.

The above chart is very important to internalize and compare with the slow recovery in economic demand for natural gas. A situation in which you have declining production and increasing demand results a bullish set of fundamentals for a commodity in that inventories will on net be declining versus seasonal benchmarks - a condition which we have previously shown is correlated with an increase in the price of natural gas.

Ultimately, I am bullish natural gas and I believe that UNG represents a solid, unleveraged play to trade it. However, there are a few stipulations to trading UNG which we'll cover in the next section.

About UNG

In my previous pieces about UNG I have discussed these concepts in more depth, so I'll be relatively brief. The problem with UNG is that it's an ETF that is trading futures and is therefore subject to roll yield.

UNG is holding the front month natural gas contract until two weeks prior to expiry - at which point it moves exposure into the second month futures contract. After expiry, the second month futures contract becomes the front month futures contract and the process repeats.

This is a natural and normal state of futures markets as well as a normal ETP's approach for tracking it. However, there's a problem that is fairly simple, but at the same time remarkably complex: roll yield.

The problem in a nutshell is this: the front month futures contract will converge to be the spot commodity at the time of expiry. In other words, if there's a difference between the spot price of natural gas and the price of front month futures contract, this difference will shrink to basically be nearly zero at the time of expiry.

Unfortunately for UNG, there tends to be a strong degree of contango - that is, the futures contract is priced above the spot price of natural gas - present in the curve. For example, over the past decade, the front month futures contract has been priced over the spot level of natural gas in about 83% of all days.

Ultimately, this means that UNG is losing from roll yield - it is holding futures contracts which are typically priced above the spot price of natural gas and during the month this difference shrinks with the futures prices rolling down to be the spot price of natural gas.

If you understood this last section, then you've got the major problem with a long-term holding in UNG. Since it is exposed to this roll yield, it will almost always be losing small amounts of return to the "roll down" as futures converge towards spot. Over a period of a few days, it may not be noticeable. However, based on the historic structure seen in the curve, I estimate that roll yield is dragging down the performance of UNG by 12-14% per year. In other words, if you hold UNG for a year, you will need to see the price of natural gas increase by over 10-12% to just be breakeven. Natural gas is a very volatile commodity so this can easily be done - however, investors should be aware of this ongoing drag upon returns.

For a strategic trader, I suggest waiting until natural gas hits a fresh 1-month high before buying UNG. This will allow the trader to catch most of the upside in a newly-emerging bullish trend while at the same time protecting the trader from constant exposure to negative roll yield.

Conclusion

The technical picture is starting to show bullish momentum in UNG. Economic demand for natural gas is recovering while production is declining - a classic recipe for higher prices. UNG is exposed to negative roll yield so investors could consider a tactical approach to entry and exit.

Analyst’s 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.