Profiting from a contangoed natural gas market.
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.
First Generation Futures-Based Products: A Catch-22
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.
UNG has an additional problem. Contango-related drawdowns tend to be largest near expiration and less severe in contracts further out on the curve. So when holding a contract to maintain exposure to natural gas, using the front-month requires that you risk taking the largest potential drawdown on a monthly basis. While spot gas has been trounced by buoying supplies, contango has driven UNG to even deeper lows. In 2011, the U.S. natural gas wellhead price dropped 33%, while UNG fell 46%.
The Second Generation
In response to the persistent contango-driven underperformance of UNG, a second generation of commodity products was launched. These second-generation commodity ETFs invested in futures contracts of varying expiration months. In the natural gas space, United States Commodity Funds launched United States 12 Month Natural Gas UNL. The fund invests an equal portion of its pool of net assets in each of the first 12 months of futures contracts.
Investing further from expiration allows the product to mitigate much of the negative roll-yield that is so pronounced in the front month. In 2011, the strategy cut UNL's loss to 39%, versus UNG's 46%.
In either case, as enticing as current prices make natural gas seem, holding on to a long position can be a very expensive proposition.
Using Contango to Your Advantage
You might be wondering why you can't gain from UNG's persistent contango-driven drawdowns. The answer is that you can. Being a large and liquid exchange-traded fund, shares of UNG are easy to borrow. That being said, shorting is not a problem from an execution standpoint. We would not, however, recommend an outright short.
Even in the event that your call is correct, natural gas prices can be extremely volatile, and your risk-adjusted returns might not look so enticing. Additionally, remember that UNG invests in front-month futures. Because these contracts have the least amount of time until expiry, they are the most sensitive to the movements in the spot price of the commodity. By using both first- and second-generation products together, however, investors may be able to benefit from the persistent level of contango, without the volatility.
We saw earlier that UNL's contango-related declines are substantially less than UNG's. At the same time, UNL is going to maintain sensitivity to spot natural gas price movements (albeit less than the front month). Those inclined to believe that natural gas prices are likely to remain low until the supply glut abates can capture a contango-driven gain by shorting UNG. At the same time, establishing a long position in UNL will hedge out much of the return associated with movements of the spot price. If one were to have invested in such a strategy since January 2010, when both products were available for trade, he would have done quite well. Spreading UNG against UNL and rebalancing to 50/50 on a monthly basis received a 5% annualized return. While the return is not a home run by any means, the strategy's volatility, as measured by standard deviation, would have been a mere 2%. The setup afforded investors very high risk-adjusted returns, posting a Sharpe ratio of 2.75. Before executing this type of strategy, check with your brokerage house to determine the costs of borrowing UNG to short. UNG trades over 83 million shares a day, so borrowing shares should not be problematic.
We must caution investors. While ETFs make implementing this calendar spread strategy very easy, do not jump in blind. This strategy has worked until this point because of a persistent state of contango, which was driven by a monumental oversupply within the spot market. If the supply/demand situation shifts to support rising prices, this type of strategy may not present such enticing returns, on a nominal or risk-adjusted basis.