Natural Gas ETFs: Down, But Not Out

by on July 9, 2009

Among the strongest trends to emerge in the first half of 2009 is the sharp increase in commodity prices, driving up prices of direct commodity ETFs, ETFs that focus on specific commodity-related sectors (such as KOL and GDX), and emerging markets ETFs that focus on resource-rich nations (such as Peru and and Indonesia). What’s remarkable is that commodity prices have risen across-the-board…almost. Natural gas ETFs are down sharply over the first half of the year, with GAZ down nearly 50% year-to-date and UNG down 47%. On top of the disappointing returns, regulators are now looking into expanding regulation of speculative trading in commodities, targeting USO and UNG in particular. Despite the sustained downward pressure and thorny regulatory issues, don’t count out natural gas just yet.

Long Way Down

Unlike crude oil, which can be and frequently is transported from resource rich parts of the world (the Middle East, South America, etc.) to oil-thirsty countries, natural gas is largely a local commodity. Because of its low density, natural gas is difficult to store and transport, requiring networks of pipelines to move from one location to another. Iran’s proven natural gas reserves are second in the world to only Russia, but geopolitical tensions in Middle East will never have a major impact on natural gas prices in the U.S. In fact, a significant amount of natural gas in Iran is simply burnt off, or flared, each year due to the lack of sufficient infrastructure. This notion is frequently lost on investors, including those who hold themselves out to be experts.

So if the political situations in Russia and the Middle East aren’t pushing down natural gas prices, what is? The simple answer it that domestic supply is through the roof. According to the Energy Information Association, natural gas in underground storage was recently at about 2,800 billion cubic feet (bcf), an increase of more than 25% from year-ago levels. In addition, the Potential Gas Committee of the American Gas Association published a report that U.S. natural reserves have jumped by 35% to more than 1,800 trillion cubic feet (due primarily to the discoveries of new shale fields over the past several years). The recently-discovered Haynesville Shale in northern Louisiana alone could hold 200 trillion cf of natural gas.

The demand side of the equation has also slumped, exacerbating the downward spiral for natural gas prices. As the U.S. economy has contracted, domestic production cutbacks have pinched demand, leading natural gas producers such as Chesapeake Energy and Devon Energy to dramatically reduce their activities. According to data from Baker Hughes, the number of active oil and natural gas rigs was just under 900 in June 2009, down from more than 1,600 in September.

Heating and cooling demand can also be a driver of natural gas prices, but unless temperatures depart drastically from their traditional ranges, prices aren’t likely to experience any major jumps. Moreover, betting on weather is obviously inherently unpredictable, perhaps even moreso than the stock market.

Due For A Comeback?

Despite the deep declines in prices already and the countless pitfalls that could send them plummeting further, there are some reasons to be bullish on natural gas ETFs. The Obama administration has slowly turned its attention from the economic crisis, and is now focusing intently on climate change legislation, as evidenced by the central role that this topic played at this week’s G-8 Summit in Italy. Brian McMorris proposes that one of two scenarios is likely to play out, with either alternative potentially providing a boost to natural gas prices. If a carbon tax is enacted, McMorris theorizes that natural gas will become more competitive, since it is much cleaner than fossil fuel alternatives such as oil and coal. A “cap and trade” policy could have similar benefits for natural gas demand.

Another industry expert sees the supply side of the equation pushing prices back up. “Today’s gas prices are clearly not strong enough to support a North American rig count that is high enough to prevent a very severe and unprecedented decline in North American gas production,” noted Chesapeake Energy CEO Aubrey McClendon recently. “This will set the stage for a dramatic reversal of natural gas prices sometime this fall or winter.”

The long term outlook for natural gas holds some promise as well. Billionaire T. Boone Pickens continues to relentlessly promote compressed natural gas as an alternative automotive fuel, recently campaigning in Washington for legislation that would extend tax breaks to the purchase of natural gas vehicles. Adding fuel to the fire recently was Freightliner Trucks, a division of Daimler that introduced its first natural gas-powered truck. The company claims each truck can save $6,000 per year in fuel costs. Despite Pickens’ relentless efforts, natural gas cars have largely been seen as a pipe dream to this point. Although many cities are utilizing the technology in buses, refilling stations are few and far between, with only 1,100 nationwide. As such, there is huge potential for expansion of the industry if effective tax incentives are established in the coming months.

I feel obligated to note that UNG and GAZ don’t invest in natural gas directly (the aforementioned storage issues are but one of the limitations) but rather in futures contracts. As such, these ETFs may not move exactly in line with spot prices, and may experience price movements as the issuer rolls forward expiring contracts.

iPath DJ-AIG Natural Gas Total Return Sub-Index (GAZ):

GAZ

United States Natural Gas Fund (UNG):

UNG

Disclosure: No position at time of writing