• / Free eNewsletters & Magazine
  • / My Account
Home>Research & Insights>Investment Insights>Do All Natural Gas ETFs Lose Money?

Related Content

  1. Videos
  2. Articles
  1. Is There a Good Way to Invest in Natural Gas With ETFs ?

    Value investors interested in taking a position in beaten-down natural gas have to deal with the contango headwind.

Do All Natural Gas ETFs Lose Money?

Profiting from a contangoed natural gas market. 

Abraham Bailin, 04/09/2012

Today natural gas prices sit near 10-year lows. The appreciation that the broader commodity space has seen over the past few years has prompted interest in the laggardly energy commodity. At the root of rock-bottom natural gas prices lies a persistent supply glut that does not look to abate anytime soon.

While establishing a long position in natural gas at historically low prices certainly seems enticing, there are a number of obstacles that complicate the issue. Here we discuss the nature of the natural gas industry, how the fundamentals have impacted the futures markets, and how to gain both long and short exposure to natural gas and the costs and benefits of each.

Laying the Groundwork
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. Horizontal and slant drilling techniques allow single drilling platforms to both increase well productivity and tap previously inaccessible formations. Both mark leaping advancements in oil-and-gas extraction technology and have led to the supply glut that we find in the natural gas market today.

Over the past five years, natural gas storage in the United States has averaged 1,537 billion cubic feet, or bcf. Today's natural gas storage figure sits at 2,437 bcf. At the same time, gross withdrawals have also ramped up. The five-year average sits at 2,202,413 million cubic feet, or mmcf, while the most recent EIA figure pegs January withdrawals at 2,577,937 mmcf.

It is important to remember that global transportation of energy products is not nearly as pervasive in the natural gas industry as it is for crude oil or coal. While compressed and liquid natural gas can be transported via ship or truck in small quantities, supply systems for natural gas are generally stationary. The immobile and regional nature of natural gas markets has made the supply overhang in the U.S. all the more impactful.

Fundamentals Meet Futures
The recent proliferation of exchange-traded funds has allowed for convenient access to natural gas, but there are a number of important caveats. Because physically backing an ETF with actual natural gas is prohibitively logistically burdensome, all exchange-traded products use futures contracts to gain exposure to the commodity. The mechanics of the futures markets do not allow investors to take a straightforward long exposure to natural gas.

Futures contracts grant the right to buy or sell a fixed quantity of a commodity at some point in the future. This allows expectations of future developments to be baked into the price of the futures contract, which inevitably causes the futures contract to deviate from the spot price. As a futures contract approaches its expiration date, it effectively becomes exchangeable for the spot commodity. This causes the futures price to converge with the spot price upon expiry.

If one purchases a contract at a premium to spot, a situation known as "contango," the position will depreciate in value over its life, assuming that the spot price does not move. In order to avoid physical delivery and to maintain exposure, ETFs must sell contracts before they expire and purchase contracts further out on the futures curve, "rolling" the position forward. This situation has proved crippling for United States Natural Gas UNG. While ballooning supplies have forced spot natural gas down, the front-month futures strategy has seen drawdowns several orders of magnitude larger. From January 2009 to December 2011, spot gas fell by 32%. Over the same time period, UNG gave up over 82% of its value.

Abraham Bailin is an ETF Analyst with Morningstar.
blog comments powered by Disqus
Upcoming Events
Conferences
Webinars

©2014 Morningstar Advisor. All right reserved.