Natural Gas ETF Rally: Hot Air Or The Real Thing?

Includes: FCG, UNG
by: Tom Lydon

U.S. Natural Gas Fund (NYSEARCA:UNG) has appreciated by almost 30% from its bottom near the $14.24 a share level. This trend can sustain if supply continues to wane and demand holds steady.

"Recent years have seen the expansion and refinement of new natural gas collection techniques. North American shale formations have provided substantial supply increases through the use of hydraulic fracturing, or 'fracking,' and horizontal drilling technologies. Fracking involves forcing pressurized fluids into the gas-rich rock formations to cause cracking, allowing for the access of otherwise trapped gas. Both advancements in oil-and-gas extraction technology and have led to the supply glut that we find in the natural gas market today," Abraham Bailin for Morningstar wrote in a recent article.

The U.S. Energy Information Administration revealed a smaller-than-expected increase in natural gas inventories, stoking a rally in natural gas futures that have languished near a decade low.

UNG has gained 9% in the last week. However, an investment like an ETF that uses futures contracts has magnified the recent over-supply that the commodity has experienced, as natural gas prices were depressed, the fund uses a front-month futures strategy that had seen losses far greater.

"UNG invests in front-month natural gas futures contracts and rolls its position forward to the next nearest to expiration contract on a monthly basis. The supply glut we spoke of earlier has depressed the price of spot gas, keeping the market in a persistent state of contango. Over time, this has forced UNG to replace expiring contracts with more expensive, later-dated contracts, creating a string of losses," Bailin wrote.

According to the U.S. Energy Information Administration, natural gas demand is expected to rise in 2012, compared to 2011. The drop off in natural gas consumption was due to lowered production activity among businesses and a milder-than-expected Winter.

Another ETF to play natural gas is the First Trust ISE-Revere Natural Gas Index Fund (NYSEARCA:FCG). The fund is equity-based so the performance differs from UNG.

U.S. Natural Gas Fund

(Click to enlarge)

Tisha Guerrero contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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