Natural Gas: Why Prices Are Headed Lower, And How To Profit

by: John M. Yenkes

As natural gas futures drop below $2 per mmBTU for the first time in over a decade, now is a good time to discuss some of the fundamentals underlying the move lower, and explore some potential trading strategies for the commodity.


A drop in demand caused by mild winter conditions across the U.S., along with a record level of new supply from nascent shale gas technology (fracking) are the main economic drivers that have pushed natural gas prices 34% lower this year.

Regarding demand, the NOAA recently released a report finding 15,000 state and local temperature records were broken in the last month alone, making it the warmest March ever recorded in U.S. history. Over half of U.S. households rely on natural gas for their winter heating needs. The above average temperatures weighed heavily on demand, which fell nearly 20% below winter averages. This decrease in demand also pushed stockpiles toward a seasonal high of 2.5 trillion cubic feet, also a U.S. record for March. As warmer weather begins to drive electrify demand for running air conditioners, prices typically begin to firm up in late spring.

This year will be different. Supplies are forecast to continue climbing and reach a record 3.9 trillion cubic feet by the end of the third quarter. Although there is no way to precisely measure the exact amount of working underground storage capacity, conservative estimates place the number around 4.1 trillion cubic feet. This number is ominously close to the total estimate of 3.9 trillion cubic feet that will be reached before the end of the year. Although natural gas is currently 6-8 times more expensive in other areas of the world (generally $12-$15/mmBTU), the U.S. currently lacks the infrastructure necessary to capture any arbitrage opportunity offered by exporting liquefied natural gas (LNG) into to other markets.

On the supply side, total U.S. natural gas production in 2011 was a record 29 trillion cubic feet, and the output continues to rise. Although some operators have started shuttering dry rigs, this decrease is being offset by an increase in the number of more profitable liquid oil rigs. As a byproduct to liquid oil production, these rigs produce a considerable amount of natural gas.

The result of all this could be a scenario where underground storage reaches full capacity this fall, while additional supplies continue to be delivered. It's not unreasonable to predict prices close to $1/mmBTU later this year. In the extreme case, gas for immediate delivery could approach zero. While it's hard to imagine free energy, given that the U.S. has no capacity to export LNG, if there is nowhere to store new supply and the demand curve is maxed out domestically, simple economics say the price should be close to $0.

Trading Strategy

Given the fundamentals provided above, I believe the overall trend of lower natural gas prices will continue. Several options exist for investors and traders in natural gas. United States Natural Gas Fund (UNG) is an LP that tracks the spot price of natural gas at the near month contract. With the natural gas market currently in contango (near term prices lower than future months), this is a good candidate for shorting or buying long dated put options on.

For those comfortable with a greater degree of risk/reward, you might consider shorting ProShares Ultra DJ-UBS Natural Gas ETF (BOIL), a leveraged ETF that tracks 2x the daily price action of natural gas. This strategy will also capture gain from the natural price decay inherent in leveraged ETFs. Note, this ETF has a twin ProShares UltraShort DJ-UBS Natural Gas ETF (KOLD), which tracks 2x the inverse of daily natural gas prices.

I would advise against buying KOLD, as well as the even higher leveraged ETNs of VelocityShares 3x Long Natural Gas ETN (UGAZ) and VelocityShares 3x Inverse Natural Gas ETN (DGAZ), as such products do not track the price of natural gas over long periods of time, and in the case of leveraged ETNs, these do not even accurately track prices intraday.

Disclosure: I am short UNG.

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