Why Nat Gas ETFs Are Quietly Surging

Natural gas prices have almost doubled from their lows.

The natural gas market has been an unmitigated disaster for years now. For eight years, ever-growing supplies of the fuel pushed prices lower and lower. The climax came in March of this year, when benchmark Henry Hub prices crumbled to a 17-year low around $1.61/mmbtu.

On an inflation-adjusted basis, things looked even worse. In real terms, this year's low was the cheapest price ever for Nymex natural gas futures, which began trading in 1990.

Anyone invested in natural gas, such as those holding the United States Natural Gas Fund (UNG) or the First Trust ISE-Revere Natural Gas Index Fund (FCG), was hammered. Both ETFs hit all-time lows earlier this year.

For bulls, the situation was hopeless. The U.S. had just experienced its warmest winter on record―significantly reducing demand for the heating fuel―while production stubbornly held close to record highs despite sinking prices.

Unexpected Price Turnaround

There was no reason to believe that natural gas would be rallying anytime soon. But just as they often do, prices turned around when everyone least expected it. Today natural gas stands above $3, or 90% above its recent lows. What sparked this surprising rise in one of the most-beaten-down commodities in the world?

NatGas Price 

NatGas Overtakes Coal

Out of all the factors that have driven natural gas higher in the last few months, perhaps the most important is demand; particularly, electric power. This year, demand for natural gas from power plants is up around 8%. That's on top of the nearly 19% growth that demand in this segment saw last year.

Low prices have encouraged utilities to switch from burning relatively dirty coal in favor of cleaner natural gas. In fact, this year the latter is on track to replace the former as the most widely used fuel in the country for generating electricity.

On a year-to-date basis through July, natural gas' market share of 34.2% easily topped coal's 29%. For comparison purposes, 10 years ago, natural gas only fueled 20% of the country's electricity generated compared with 49% for coal.

Electricity Generation By Source (2016 YTD)

Source: Energy Information Administration

The big jump in natural gas demand from utilities―in combination with the fifth-hottest summer on record―helped slow the pace of seasonal inventory builds during the spring and summer months. In fact, one week at the end of July, natural gas stockpiles actually decreased by 6 billion cubic feet (bcf), the first summer withdrawal in 10 years.

At 3,680 bcf, inventories today stand only 46 bcf above the year-ago level, down from a whopping 1,000 bcf surplus in March, when prices bottomed out.

Sliding Output & First-Ever NatGas Exports

On its own, rising demand probably wouldn't have been enough to spark a rebound in natural gas. Something had to give on the supply side―and it has, at least a little bit.

U.S. natural gas production, which had for so long confounded analysts with its resilience, is finally drifting lower. It's not a huge move, but the latest figures from the Energy Information Administration show that output is down about 3 bcf/d from its recent highs.

Also helping to tighten the market are natural gas exports. In February, Cheniere Energy began exporting super-cooled liquefied natural gas from its Sabine Pass terminal, the first-ever LNG export from the U.S.

U.S. net LNG exports are currently modest―they were 0.3 bcf/d in July―but this is a monumental shift from the old paradigm of the U.S. being a net LNG importer, which it was for years.

US Net LNG Imports

Export capacity is expected to continue growing in the coming years. When complete, the six liquefaction units at Sabine Pass will have the ability to export 4.2 bcf/d of natural gas overseas.

Four other terminals that are currently under construction will add another 6.5 bcf/d of export capacity between now and 2020.

Worst Has Likely Passed

Surging electric demand, sliding production and growing exports were the ingredients that sparked this year's natural gas rebound. But that doesn't mean it's "all clear" for the notoriously volatile commodity.

The underground natural gas resource base remains tremendous. If prices move high enough, drilling will quickly pick up and production will rise again. By the same token, higher prices will discourage natural gas exports by reducing the spread between domestic prices and overseas prices―and will discourage demand growth by making coal a more viable competitor.

Those caveats aside, it does look like the worst has passed for natural gas prices. The fuel remains well positioned to compete against other forms of energy domestically and abroad in the coming years. As demand rises, supply will eventually need to bounce back to meet the needs of consumers. Likewise, prices must move to a high-enough level to encourage producers to drill again.

As long as natural gas prices are rising, energy ETFs such as the aforementioned FCG or the broader SPDR S&P Oil & Gas Exploration & Production ETF (XOP) should benefit.  

Futures-based ETFs like UNG are likely to underperform due to the effects of roll costs from contango. As can be seen from the chart below, UNG is only up 3.7% year-to-date, well below the 21% gain for FCG and the 29.2% gain for XOP. Similarly, since the lows in March, the fund is only up 54.8% compared with the 90.2% increase for natural gas futures. 

YTD Returns For FCG, XOP, UNG

Contact Sumit Roy at [email protected].