NatGas Investing Not For Faint Of Heart

Commodities have been doing horribly; that's not news to anyone. But in a space where prices have continually sunk to new lows across the board, one commodity has managed to outdo them all―natural gas.

The worst-performing commodity of the year, natural gas, is down 30 percent in 2015. Due to the ill effects of roll costs from contango, the United States Natural Gas Fund (UNG | B-94) has done even worse, losing 35 percent of its value.

At the same time, equities tied to natural gas have been decimated year-to-date, with the First Trust ISE-Revere Natural Gas ETF (FCG | B-95) losing a whopping 46 percent.

YTD Returns For Natural Gas Futures, UNG, FCG

Unrelenting Production Growth

The problem for natural gas is simply that the country has too much of it. Despite the fact that prices are close to the lowest levels in more than a decade below $2/mmbtu, production hasn't flinched. According to the latest data from the Energy Information Administration, output in the U.S. stood at a near-record 81.7 billion cubic feet/day as of last week, up 3 percent from a year ago.

U.S. Lower 48 Natural Gas Production (bcf/d)

To many, that statistic is confounding. Drilling activity in the energy patch collapsed during the past year due to the simultaneous decline in oil and natural gas prices. Surely that would impact production.

At least for oil, it is having an impact. Output of crude in the U.S. is down more than 5 percent from its peak levels. For natural gas, the story is obviously very different.

Large natural gas producers like Range Resources and Southwestern Energy continue to report all-time-high production levels, while calling for more growth in the future. The only takeaway is that the marginal cost of natural gas production is much lower than anyone had imagined.

Demand Disappoints

On the other side of equation is demand, and it's been somewhat disappointing. Industrial demand is actually down marginally this year in spite of the growing economy.

On the other hand, electric power demand has surged, rising nearly 20 percent year-over-year through July. However, the increase is a reflection of significant amounts of coal-to-gas switching and not something that will be repeated year after year.

Because natural gas prices are currently so low, when possible, utilities have switched from burning coal to burning gas. The move has decimated the coal industry, which simply can't compete with relatively clean and abundant natural gas. The largest coal producers in the U.S., such as Peabody Energy and Arch Coal, are all on the verge of bankruptcy, with stock prices close to zero.

(Incidentally, the two ETFs tied to the coal industry have held up better than one might expect thanks to their international exposure. The Market Vectors Coal ETF (KOL | C-5), which holds coal producers from around the world, is down only 41 percent this year, while the GreenHaven Coal ETF (TONS | F), which holds European coal futures contracts, is down 17.3 percent.)

YTD Returns For BTU, ACI, KOL, TONS

Most of the short-term switching that can be done from coal to gas has already been done. Going forward, natural gas will likely continue to take market share from coal, but at a slower pace.

Inventories Bloated

The combination of robust supply and a mixed demand picture has kept upside pressure on natural gas inventories. As of last week, stockpiles stood at 3,814 billion cubic feet, 12 percent higher than last year.

From a seasonal perspective, inventories tend to peak around early November before steadily declining through March as the winter-heating season boosts demand.

However, with weather forecasts calling for warmer-than-normal temperatures for the next couple of weeks, inventory builds could continue for a while longer. It's very likely that in the coming weeks, stockpiles will surpass the record-high of 3,929 bcf set in 2012.

Long-Term Exports & Demand
Given this dismal outlook for natural gas, is there any hope of a turnaround in the future? Probably not in the short term. Longer term, it's possible, but that hinges on a few factors. Any recovery will have to come from the demand side, because it certainly doesn't look like supply will be slowing down anytime soon.

The biggest area of potential gains is in the electric power segment and the liquid-natural-gas export segment. As stated previously, increases in demand for power generation will be smaller than they were this year, but that's a steady source of growth that is likely to continue as utilities transition from dirty coal toward cleaner natural gas.

Meanwhile, the U.S. market may get some supply relief as other countries take some of this abundant resource off its hands. In January, Cheniere Energy plans to ship its first cargoes of liquefied natural gas, kicking off a new era of U.S. natural gas exports. This is a sharp reversal from years past when the U.S. was a net importer of the fuel.

From current levels around zero, exports may rise to 8.5 billion cubic feet per day by 2019, according to Charles Blanchard, an analyst at Bloomberg New Energy Finance. That represents about 10 percent of current production, and in combination with demand gains in the power sector, could be enough to fuel a meaningful rebound in prices.

Playing The Bounce

If that happens, natural gas equities will surely follow suit―though it could take a few years for this bullish scenario to develop. The aforementioned FCG, an equal-weighted exchange-traded fund comprising natural gas producers, is the best pure-play ETF on the market.

With a basket of equities, an investor doesn't have to contend with the hazards of holding futures, which will take a big bite out of an ETF’s returns like UNG over longer time periods.

FCG could certainly decline further from here―it's been a falling knife until now. In a worst-case scenario, the natural gas market could remain mired at low levels for years, as it did in the 1990s.

That's the risk an investor has to contend with. But buying into one of the most hated commodities in the market is a high-risk/high-reward bet, best suited for only the most daring investors.

Contact Sumit Roy at [email protected].