Six Reasons UNG Is Due For A Comeback

by on April 20, 2010 | ETFs Mentioned:

The United States Natural Gas Fund (UNG) has been one of the great ETF success stories of recent years. Since its inception in April 2007, it has become one of the largest and most popular exchange-traded commodity products. The fund saw cash inflows of more than $5.5 billion in 2009, and currently has more than 400 million shares outstanding. But the fund’s success in attracting assets hasn’t been matched by a successful investment return. Unfortunately for investors responsible for this growth, UNG has been one of the worst-performing ETFs in recent years, losing more than 50% in 2009 and already sliding another 30% this year (see UNG’s historical performance).

In addition to the adverse impacts of contangoed futures markets, natural gas ETFs have been hit by a perfect storm of negative fundamental factors. New technological developments and massive discoveries of resources have caused supplies to balloon, while the recent economic downturn sapped a significant portion of industrial demand from the market. While equity markets have staged a nice recovery, the rally has been driven in large part by expectations; demand for many raw materials and energy sources is yet to fully materialize. With no demand to match surging supplies, prices have slid steadily lower.

Despite the prolonged downward slide, some investors are optimistic that natural gas prices will head higher in coming months. Below, we profile six trends that could reverse UNG’s freefall:

1. The Price of Crude Oil / Natural Gas Is Out Of Whack

UNG’s assets have surged in size in recent years in part because investors noticed that the ratio of crude oil to natural gas prices had deviated significantly from its historical average, and anticipated that this divergence was reflective of short-term market fluctuations. But so far, the gap has only grown, as the relationship between the two energy sources has weakened considerably.

At its current level of just over $80 per barrel, crude oil is about 20 times the price of a million British thermal units, which recently slipped below $4/MMBtu. That ratio has fluctuated historically, but has generally stayed pretty close to 10 times. In order to get back to this norm, natural gas prices would need to double, which would still put them well below levels touched only a few years ago.

Crude oil and natural gas aren’t perfect substitutes. But with gas attractively priced relative to oil, an intermediate term shift away from crude and towards gas isn’t inconceivable.

2. Big Oil Is Making A Big Bet On Natural Gas

The energy sector has seen a string of acquisitions in recent months that all hint at expectations of an increased interest in natural gas going forward. Late last year, Exxon Mobile acquired XTO Energy, one of the fastest-growing energy producers in the U.S. XTO’s resource base is the equivalent of 45 trillion cubic feet of natural gas, including shale gas, tight gas, coal bed methane, and shale oil.

In February, Schlumberger agreed to acquire Smith International, a supplier of products and services to gas production and exploration companies. The Smith acquisition came after Schlumberger rival Baker Hughes bought BJ Services last year, snapping up one of the leading providers of pressure-pumping services critical to natural gas extraction. And most recently, Apache and Mariner agreed to merge, combining two firms with significant oil and natural gas assets.

Big Oil is clearly betting that natural gas will be expanding its market share in the global energy market in coming years, as several major oil companies are taking steps to expand natural gas operations. It seems unlikely that these rich acquisitions would be occurring if prices were expected to continue to slide. Moreover, Big Oil’s buying spree gives natural gas another proponent with an incentive to stabilize and increase prices.

3. Alternative Energy Has Hit A Wall

With governments throughout the world facing unprecedented fiscal crises, subsidies to still-nascent clean energy industries have been drastically cut back, or in some cases eliminated altogether. European nations are bracing to bail out one of their neighbors, and have cut off support to wind and solar energy industries (see Solar ETFs: Headed For A Burnout). Some alternative energy ETFs have declined nearly 20% already in 2010, as government assistance has eroded profit margins.

Wind and solar energy aren’t dead, but their growth curve certainly seems to have flattened out a bit in the wake of the recent economic downturn. The road to economic feasibility has been extended as funding has cut off, leaving fewer clean energy alternatives ready to alleviate reliance on foreign oil in the short term. This could create an opportunity for natural gas to step in.

4. GECF Could Become The Next OPEC

Ministers from the world’s 11 largest natural gas producers, who in aggregate account for 70% of global reserves, have agreed to work to index natural gas to oil, saying that such steps are necessary to encourage investments in exploration and production. Algerian Energy Minister Chakib Khelil expressed hope that the meeting of gas-producing nations would “mark a new era for our organization.” He also said that declines in exports to the U.S. have been a major factor in pushing global prices lower.

Khelil insisted that a “new model of cooperation must be devised” in order to encourage long-term investment. Qatar’s Energy Minister Sheik Abdullah bin Hamad al-Attiyah echoed similar sentiments, telling reporters that the bloc of countries “must find a mechanism for a just price for gas and to stabilize the market.” Natural gas was once strictly a local commodity, but technological developments have made storage and global transport feasible, potentially altering the universe of suppliers available to end users.

Several member countries reportedly pushed to form a cartel-like organization that could influence prices by implementing output quotas. Analysts note that a cartel-like structure is unlikely, since agreements to production cuts would be nearly impossible to agree upon. But the recent meeting indicates that the Gas Exporting Countries Forum is serious about stabilizing gas prices.

5. EPA’s Regulatory Rampage

Last month, the Environmental Protection Agency (EPA) announced that it was beginning an investigation into the drilling technique known as hydraulic fracturing, or “fracking,” that has contributed to the surge in natural gas supplies in recent years. “Our research will be designed to answer questions about the potential impact of hydraulic fracturing on human health and the environment,” said Paul Anastas, assistant administrator for the EPA’s Office of Research and Development.

Fracking involves injecting a mixture of water, sand, and chemicals into rock formations to stimulate natural gas production. Some environmental groups claim the practice is unsafe and think it should be regulated by the federal government. Separately, the House Energy and Commerce Committee is conducting its own investigation into the effects of fracking.

The outcome of the investigation is neither certain nor imminent–the EPA said its study could take two years to complete–but it is clear that the impact could be significant. Shale rock formations account for as much as 20% of U.S. natural gas supplies, meaning that any ruling pleasing to environmentalists could restrict supplies.

6. Analyst Estimates > Futures Curve

Credit Suisse expects natural gas to hit $4.66 this year, which represents a significant reduction from its previous forecast of $5.25/MMBtu. The futures curve for natural gas contracts rises throughout 2010, but doesn’t go above that level until December, and averages just $4.38 between May and December. Wall Street isn’t always right, but if the projections from some big banks are even close to accurate, UNG could be due for a turnaround.

Headwinds Remain

As many investors know by now, the spot price of natural gas is only one of the factors that impacts the share price of UNG. And sometimes, it’s not even the most significant one. At present, contango in natural gas futures markets–the same factor that was responsible for a significant portion of last year’s losses–is creating some strong headwinds for UNG. The curve slopes steadily upwards through January 2011,  with futures contracts for the first month of next year recently trading at more than a 35% premium to May contracts.

So keep in mind that upward movements in spot natural gas prices might not be enough to lift UNG.

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Disclosure: No positions at time of writing.