UNG’s Insurmountable Obstacle

by on August 17, 2010 | ETFs Mentioned:

For investors who have dabbled in commodities in recent years as the growth of the ETF industry has democratized this asset class, natural gas has been one heck of a frustrating bet. Even putting aside the impact of contango–which has had a major impact on a number of futures-based commodity ETPs–natural gas has been a cruel investment choice. In recent years, natural gas has been billed as the “fuel of the future,” as a number of high profile and deep-pocketed supporters have led the charge promoting the fuel as the solution to America’s energy crisis [see Natural Gas ETFs: Seven Ways To Play].

Natural gas hasn’t exactly disappeared from the headlines–far from it in fact. More and more vehicles running on natural gas are now on the road, and the fuel has been at the core of countless proposals designed to decrease dependence on foreign oil. President Obama recently endorsed a plan from Senate Democrats to spend $4 billion on natural gas-powered vehicles; that money will be used to offer rebates for compressed natural gas vehicles.

All indications are that natural gas will continue to claim a bigger portion of the domestic energy market share in coming years. Big Oil is certainly making a bet on that scenario; over the last year a number of large oil firms have made major acquisitions in the natural gas space, diversifying their portfolio to include companies operating in all segments of the natural gas industry. After Exxon acquired XTO Energy in a $30 billion deal late last year several other energy firms–including Schlumberger and Baker Hughes–snatched up smaller firms, confirming the industry’s bullish sentiment towards the natural gas sector. Activity has continued to ramp up this summer, and many experts see more acquisitions in the not-so-distant future.

Despite the obvious interest in natural gas, prices remain depressed; contracts currently trade for well less than half the levels touched in 2005 in the wake of the Gulf Coast hurricanes. The primary reason for UNG’s dismal performance–the fund that now has $2.5 billion in assets has lost about 85% of its value since inception in April 2007–has been the pricey “roll yield” incurred because of contango in futures markets [see What's Wrong With UNG]. But there are other, more fundamental hurdles with which investors in natural gas must contend. And these aren’t likely to disappear any time soon, making natural gas ETFs a tough long-term bet to win.

Growing Reserves

Reserves of the fuel are astounding in size, with every week seemingly bring reports of a massive new natural gas discovery. Moreover, technological advancements threaten to make the commodity more global in nature, potentially expanding the supply base for end users significantly in coming years.

Earlier this week Chevron announced a huge natural gas discovery off the coast of Australia. The newfound reserve represents the largest of the firm’s nine natural gas discoveries over the last year. Separately on Monday, Woodside Petroleum announced its second natural gas discovery of the week off of the Australian coast, highlighting the incredible pace at which global supplies are expanding.

News of natural gas discoveries aren’t just coming from down under. Brazilian oil and gas company OGX Petroleo e Gas Participacoes SA said recently that a natural gas discovery in the Parnaiba Basin could hold as much as 15 trillion cubic feet of the gas. The size of the discovery prompted OGX to increase its plans for the region; it will now build 15 new wells, up from the previous plan for seven. Dozens of new natural gas reserves have been reported in the Gulf Coast in the last two years, one of which is believed to be the largest natural gas field in the lower 48 states (the Haynesville Shale is estimated to house 250 trillion cubic feet of recoverable gas).

LNG Could Doom UNG

Another hurdle for UNG comes from advancements in technology that may make it easier for resource rich nations to sell excess supplies overseas. Although natural gas and crude oil are often seen as substitutes, the physical properties of these two commodities are very different. Oil is a truly global commodity, regularly shipped overseas from oil exporters to oil importers. Natural gas, on the other hand, has historically been a local commodity; the physical properties of the gas make long distance transport via ships difficult from a logistical perspective and quite expensive [see UNG vs. USO: Correction or Decoupling?].

Or at least that’s how it used to be. Great strides have been made over the last ten years in the development of liquefied natural gas (LNG) technology. The practice of removing water and certain other components from natural gas in order to covert it to a form that can be more easily transported has become increasingly popular in recent years, and LNG use is expected to increase significantly over the next decade. Because LNG can be “regasified” and distribute as pipeline natural gas, it allows for long distance transport from companies with excess supply to those with sufficient demand.

Much has been made of the significant supply glut in the U.S., where natural gas inventory levels are well above five-year average levels. But the U.S. natural gas supply is a drop in the bucket compared to the amount of the fuel that some nations simply throw away. It is estimated that Iraq, which is home to some of the largest deposits in the world, burns off $70 billion worth of natural gas each year at its oil fields. If increased regional stability and continued technological advancements allow Iraq to harness that gas and sell it to overseas consumers, the natural gas market in the U.S. would experience a flood of biblical performance.

Buyer Beware

Natural gas may very well still be the next big thing, and may one day cut America’s oil demand to a fraction of its current level. But even if demand begins to accelerate at a tremendous pace, it will be hard-pressed to keep up with surging supplies. So while it may be easy to make an emotional case for natural gas and UNG as “can’t miss” investments, the fundamentals make them seem more like sucker’s bets.

Disclosure: No positions at time of writing.