Can UNG Continue Surge?

by on June 4, 2010 | ETFs Mentioned:

In early May, the United States Natural Gas Fund (UNG) hit a new all-time low, closing at $6.81 as ballooning supplies and a lingering slowdown in industrial activity continued to weigh on prices. On top of the fundamental factors, contangoed futures markets created strong headwinds for investors in one of the largest exchange-traded commodity products, causing the fund to incur a significant “roll yield” each month. But over the last month, as intensifying anxiety over weakness in Europe has battered equities and commodities alike, natural gas prices have surged, making UNG stand out as one of the few big winners during a rough losing streak.

Since bottoming out on May 6, UNG has surged more than 17%, recently trading above $8 for the first time since March. The run higher has been driven by a number of factors, and has highlighted some of the more unique characteristics of natural gas and the investment vehicles that offer exposure to the fuel. Unlike crude oil, natural gas remains largely a local commodity; the physical properties of the gas make long distance transport via tankers complicated from a logistical perspective and, in some cases, prohibitively expensive. So natural gas delivered at the Henry Hub in Louisiana, for example, never makes its way to Athens or Madrid for consumption (see Six ETFs In Focus As The Greek Drama Unfolds).

This insulation has been a blessing for UNG over the last several weeks as the odds of a debt crisis in the euro zone have guided not only markets in Europe, but those around the world. Instead, natural gas prices have reacted to developments in the local economy (i.e., the U.S.); continued manufacturing growth, job creation in factories, and bullish economic indicators from Fed branches (see UNG’s Stellar May: Proof Of A U.S. Recovery?).

In addition to a bullish demand look, developments on the supply side of the equation have also helped to boost natural gas prices. The fallout from the Deepwater Horizon oil spill in the Gulf of Mexico has begun, with the Obama administration extending a moratorium on deepwater drilling and canceling multiple lease sales that would have allowed oil companies to explore for new reserves (see Oil ETF Slides As Obama Lashes Out).

The changes rolled out to date have impacted crude oil ventures most directly. But many investors anticipate that natural gas will get caught up in the wave of environmentalist sentiment before long. Environmental groups have long argued that hydraulic fracturing, or “fracking,” a tactic widely used in completion of wells in shale-gas fields, should no longer be exempt from regulation under the federal Safe Drinking Water Act. With public outrage over the Gulf oil spill spiking and Capitol Hill sensing an opportunity to score points with environmental groups, don’t be surprised if pressure mounts to ramp up regulation of a process some claim could be contaminating drinking water (the EPA is currently conducting a study, scheduled to be completed in 2012, on the environmental and human impacts of fracking).

Massive discoveries of natural gas reserves and improvements in extraction technologies have flooded the market for natural gas in recent years, providing consistent downward pressure on prices. So any easing of supplies would be good news for gas prices.

Oddly enough, UNG’s May surge didn’t translate into increased interest from investors; the fund saw cash outflows of $267 million during the month, more than erasing the inflows from April.

Can The Surge Continue?

After gaining almost 20% over the last month, many are wondering if UNG’s rally can continue throughout the summer. There are a number of reasons to be optimistic that the natural gas ETF will continue to head higher. Widely-used measures of industrial activity have recovered sharply from lows touched during at the depths of the recession, but still remain well below pre-crisis levels; the Fed’s index of Manufacturing Industrial Production recently came in at 103.2, compared to a reading of 114.6 at the beginning of 2008. So there is certainly potential for additional expansion in the manufacturing sector, a major driver of demand for natural gas.

And despite the recent coincident surge in natural gas prices and slide in crude oil prices, natural gas still remains relatively cheap compared to historical averages. That imbalance has some hoping that natural gas will continue to gain market share in the domestic energy equation, replacing traditional sources that are imported from overseas (see UNG vs. USO: Correction Or Decoupling?).

There is at least one more factor now working in UNG’s favor. Contango in futures markets has virtually disappeared; August contracts were recently trading at a premium of less than 1% over July futures (the current holdings of UNG). Because UNG maintains its exposure to natural gas through futures contracts, the fund’s price depends not only on the market price for the commodity, but also the slope of the futures curve. Historically, an upward sloping curve for natural gas futures has eaten into UNG’s returns, responsible for a significant portion of the nearly 45% decline in value over the last year.

It’s a strange realization, but UNG is one of the purest plays on the U.S. economy in the current environment, virtually immune to the chaos in Europe and weakness in other regions of the world. If the recovery effort on the home front stays on track, expect a continued surge from UNG.

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Disclosure: No positions at time of writing.