Long Term Deals: Bad Omen For UNG?

by on December 30, 2009 | ETFs Mentioned:

After sinking steadily for most of the year, the United States Natural Gas Fund (UNG) has staged a remarkable rally in recent weeks, adding more than 15% in the month of December as inventories finally began to dwindle and optimism of a resurgence in demand in the new year mounted. Exxon’s $31 billion dollar purchase of natural gas producer XTO Energy was seen as another endorsement for the future of the natural gas industry, and the announcement of the deal sent prices sharply higher.

New Developments Could Spell Doom For UNGBut recent developments paint a far less grimmer picture. Many major producers of natural gas, such as Chesapeake Energy and Devon Energy, are now pushing their customers to sign long-term contracts, a sharp departure from previous policies that could foretell a prolonged period of reduced prices.

Historically, “energy companies have shunned such agreements because they wanted to profit when gas prices soared, as they often did, especially in advance of rising winter demand for gas heat,” writes Ben Casselman. “But huge new gas fields in Texas, Louisiana, Pennsylvania and elsewhere have led to a surge in U.S. natural-gas production, glutting the market even as the recession has sapped demand for all forms of energy.”

Earlier this year, natural gas prices fell below $3 per million British thermal units, less than a quarter of the price as recently as July 2008. Natural gas has rallied since scraping bottom in the first quarter of the year, but remains below $6  per million BTU, with hopes for a continued run-up quickly fading.

The push for long-term contracts by natural gas producers is significant because it reveals a bearish outlook on prices within the industry. In the past, producers have shied away from signing long-term deals that would prevent them from profiting if energy prices spiked, as they often did. Now, producers are pushing for deals that would preclude them from profiting during run-ups in price. “The days of double-digit gas prices in the U.S. are over,” said Chesapeake Chairman and CEO Aubrey McClendon.

Customers seem to agree, as the long-term agreements have been a hard sell. With less anxiety over a jump in gas prices, electric utilities and other users of natural gas have little incentive to lock themselves into a deal.

Strong Headwinds

The hype surrounding natural gas reached a fever pitch in 2009, as advocates of the clean-burning energy source touted the “fuel of the future” as the key to a reduced dependence on foreign oil. But while demand for natural gas may grow significantly in coming years, the supply side of the equation has already begun to swell.

Discoveries of natural gas have been made around the world in recent years, from the massive Haynesville shale in Louisiana to a new field near the Liwan reservoir in the South China Sea. Since natural gas has historically been a regional commodity, discoveries of new reserves across the world generally do not move markets in the U.S. But technological advancements are making long-distance transport of the gas more common, gradually opening up new supply sources for domestic users. Exxon Mobil recently announced plans to go forward with a $15 billion liquefied natural gas project in Papua New Guinea that could have global pricing ramifications.

Outlook For UNG

A grim outlook on the long-term prices of natural gas certainly would weigh on shares of UNG, which use near-month futures contracts to gain exposure to the commodity. But the strategy now being used by producers is not the only factor to consider. An inversion of the futures curve could provide some much-needed relief to investors who have been burned by the fund in 2009.

Despite rises in natural gas prices this year, investors in UNG have seen returns eroded by contango in futures markets, as any price increases fell short of those implied by the upward-sloping futures curve. Due in large part to seasonal factors, but influenced by the aforementioned factors that could weigh on UNG, the contango in natural gas futures markets has flipped, at least in the short-term:

The Natural Gas Futures Curve Is In Backwardation, At Least In the Short-Term

While the backwardation now showing in the market is indicative of an expected decline in prices among investors, it could potentially good news for UNG. If prices remain stable, or even increase, the fund will be able to roll its holdings at a profit, selling near-month contracts for more than the price of second-month contracts it must buy to maintain exposure.

UNG was one of the most volatile ETFs in 2009 (see UNG’s Wild Year), and with so many complex forces driving the price of this fund, there’s little reason to believe that 2010 won’t bring more of the same. For updates on UNG throughout the year, sign up for our free ETF newsletter.

Disclosure: No positions at time of writing.