March Madness In Natural Gas

March 09, 2010

 

Feeling Contango's Bite

Regular readers will remember that contango refers to the condition when a futures contract costs more at a later date than it does presently. This means higher costs during "rollover," or when investors sell out of the current month's contract ahead of its expiration and buy the next available month.

Unfortunately, certain futures-based funds that hold only one month's contract at a time, like the U.S. Natural Gas Fund (NYSE Arca: UNG), get slammed during rollover during times of contango. A steep contango curve can quickly eat away any profits that might be made on rising prices.

For example, let's imagine you'd invested in natural gas via both spot prices (the Henry Hub spot price) and futures contracts (UNG) back in March of 2009:

 

UNG vs. Henry Hub

 

In that span of the last year, if you could have somehow invested in the Henry Hub spot price, you'd have actually made a little over 2 percent. But since that would mean you'd need to take delivery of physical goods, and you can't exactly back up your tanker in Nebraska, your only real play was UNG (let's ignore UNG's 12-month cousin, the U.S. 12-Month Natural Gas Fund (NYSE Arca: UNL), since it only launched in late November). If you'd invested in UNG, you'd be down over 50 percent for the year—almost entirely due to contango's effects.

The way things stand right now, UNG investors will still lose money at nearly that rate:

 

Natural Gas in Contango

 

When compared side-by-side, the natural gas contango curves for last year and this year look remarkably similar. And while the contango we are currently experiencing isn't quite as steep as it was this time last year, it is still pretty daunting.

 

More Supply, Less Contango?

Still, contango is easing and current prices are falling, and one reason may be tied to a growing supply. For starters, the number of active natural gas rigs is rising, with 926 rigs currently drilling. While this is 42 percent off of the record of 1,606 rigs set in September 2008, it is the highest level seen since February of last year.

Although this additional source of supply won't immediately impact the price of natural gas—the rigs take time to ramp up and send product down the pipeline - it does indicate that more natural gas is on the way. And so are more rigs. In a recent Edmonton Journal article, author Peter Tertzakian notes that exploration and drilling in big shale areas continued even during the economic downturn. Therefore, more supply is coming, a fact that the market may already be taking into account:

 

"Long-dated prices for natural gas—prices being paid for delivery one-year out and beyond—have fallen by over $1.00/MMBtu (about -15%) in the past six months, with most of the drop being recorded in the last few weeks. Clearly the market is expecting more cheap gas to come to market next year and beyond."

 

All in all, this doesn't bode well for natural gas—or its investors.

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