Investors Bet Big On Worst Performing ETF Of 2017

You'd be forgiven for thinking that it was all bad for natural gas. It's one of the worst-performing commodities of the year, and products that track natural gas are among the worst-performing ETFs of the year.

Only 2 ½ months into 2017, natural gas futures are down 18.5%, while the United States Natural Gas Fund (UNG) is down 21.3% and the VelocityShares 3x Long Natural Gas ETN (UGAZ) is down 58%, making the latter the poorest-performing exchange-traded product of the year so far.

YTD Returns For Natural Gas Futures, UNG, UGAZ

In light of this dismal performance, there can't be anything good going on with natural gas, can there?

Warm Winter Masks Bullish Trends

As is the case for all commodities, the answer to that question comes back to two variables: supply and demand. Prices for natgas fell through the floor during the first two months of the year after one of the warmest winters on record sapped demand for the heating fuel.

The National Oceanic and Atmospheric Administration (NOAA) called the 2016/2017 winter, which runs from December to February, the sixth-warmest on record. According to the NOAA, the average temperature across the contiguous U.S. during the period was 35.9 degrees Fahrenheit, 3.7 degrees above average.

The warm winter devastated heating demand for natural gas―which makes up the bulk of consumption during the winter months―but it also masked some bullish developments for the commodity that were brewing under the surface.

Rising Demand, Falling Supply

Almost every category of natural gas supply and demand was moving in a bullish direction before the warm winter shook things up. During 2016, U.S. production dropped 1%; exports of liquefied natural gas increased from nothing to about 1 bcf/d; industrial demand climbed 2.5%; and electric power demand jumped 3.2%.

Prices were on their way to up, too. From a 17-year low of $1.61/mmbtu reached in March 2016, natural gas futures increased to just below $4 by the end of the year (which was a two-year high at the time).

Today natural gas is trading close to $3 after the warm-winter pullback, but perhaps Mother Nature has merely provided investors with an opportunity to buy before the recovery in prices resumes.

Natural Gas Prices

That seems to be what investors are thinking. Since the start of the year, UNG saw $79 million worth of fresh money come into the fund. Even more, the triple-leveraged UGAZ saw a whopping $748 million worth of inflows in the period.

With about $650 million in current assets under management, UGAZ is now the largest natural gas exchange-traded product on the market, surpassing the $500 million UNG. That means that many investors are betting boldly and aggressively that natural gas will bounce from here.

Reasons To Be Optimistic On NatGas

Whether a bet on UGAZ pays off is hard to say. Leveraged ETFs are notoriously difficult to make money on due to performance-drag issues from daily rebalancing. But there's reason to be cheerful about natural gas in general.

Supply is falling and demand is rising, and these variables could continue moving in a bullish direction. President Trump's "economic nationalism" agenda means that more manufacturing may be done in the U.S., lifting industrial demand for natural gas.

At the same time, demand for natural gas to generate electricity is likely to continue to surge as the commodity takes market share away from coal, as it's been doing for years. In 2016, utilities generated more electricity with natural gas than they did with coal the first time in history. Natural gas' 33.8% share topped coal's 30.4%. That compares to five years ago when natural gas supplied 24.7% of the nation's electricity, compared to 42.3% for coal.

Source: Energy Information Administration

Meanwhile, exports of liquefied natural gas are expected to increase almost sevenfold over the next five years to 8.5 bcf/d, according to the Energy Information Administration. That will reduce the supply of natural gas available in the U.S. market.

Long-Term Investors Bruised

Put that all together and you have a recipe for higher natural gas prices―maybe. The caveat is that people have been predicting the imminent rise of natural gas for a long time. The thesis makes sense, but every time a rally gets any traction, natural gas producers come in and flood the market with supply, pushing prices back down.

Investments in UGAZ, UNG and the equity-based First Trust Natural Gas ETF (FCG) have fared extremely poorly historically for this reason.

5-Year Returns For UNG, UGAZ, FCG

It could be that last year's 17-year low in prices was the reality check that producers needed to become more disciplined about their drilling activity, but only time will tell whether natural gas investors will finally be rewarded for buying into this promising fuel of the future.

Contact Sumit Roy at [email protected]