Natural Gas ETFs

The following is from Kelly Letter Note 55, sent to subscribers first thing in the morning on Sunday, August 16.

We’ve been watching US Natural Gas (UNG) as a possible buy to track what we believe will be a gradual increase in the price of natural gas when the economy gets back on an earnest growth path.

Several subscribers have written to ask if there isn’t a better way to buy into the thesis. UNG, they’ve read and noticed, has not tracked the price of gas well. One suggested alternative is First Trust ISE-Revere Natural Gas (FCG). Instead of tracking the price of gas itself, FCG tracks an index of companies that earn “a substantial portion of their revenue from the exploration and production of natural gas.” For details on the ISE-Revere Natural Gas index and a list of its component stocks, click here.

We explored in Note 45 sent July 12 whether UNG was better than three natural gas producing stocks, Chesapeake Energy (CHK), Cheniere Energy (LNG), and Southwestern Energy (SWN) in two time periods: December 2007 to end of June 2008, and end of June 2008 to July 10, 2009. The result:

It looks to me that UNG packs all the punch of the stocks, without any of the company risk. We don’t need to worry about earnings shenanigans, bad management decisions, bankruptcy, or any of the other common pitfalls of stocks. LNG obviously has problems beyond the price of natural gas, so we can strike it from the list. Against CHK and SWN, UNG performed better in the rising period and has dropped farther in the falling period.

That made UNG look like the best coiled spring in the sector. If we introduce now not just three natural gas stocks, but the ISE-Revere index of them, will the results change? Given more data available now, we’ll extend the second time frame to last Friday.

Rising period from end of December 2007 to end of June 2008:

FCG rose 42% from $22.13 to $31.39
UNG rose 74% from $36.25 to $62.97

Falling period from end of June 2008 to August 14, 2009:

FCG fell 53% from $31.39 to $14.71
UNG fell 80% from $62.97 to $12.49

Pull up a two-year chart comparing the two ETFs and you’ll see that they both traced out roughly similar patterns except for an initial price drop in UNG in January 2007 and then a departure in early December 2008. Last December saw FCG start working its way higher as UNG kept going lower. That’s led to an extreme performance divergence since then, with FCG up 13% but UNG down 54%.

Some have called that a tracking error, as if the two ETFs are supposed to follow the same underlying benchmark. They’re not. FCG follows an index of natural gas stocks while UNG follows the price of natural gas itself. Has UNG failed to track the price of natural gas?

Here are the closing natural gas prices per million British Thermal Units (mmBtu) at the Henry Hub on the first trading day of each month this year:

$5.41 January
$4.48 February
$4.36 March
$3.56 April
$3.30 May
$3.86 June
$3.63 July
$3.43 August

During that time, the price of natural gas declined 37%, and UNG declined 43%. That’s not perfect tracking, true, but it got it right in spirit. That’s all we’re trying to do here. When that price history at the Henry Hub goes the other way, UNG will ride it upward. It won’t be precise, but it will go the way the price is going and may well leave the natural gas stock index in the dust, as it did in the seven months ended in June 2008.

We’re still holding out for $12 on UNG, by the way, and it’s slowly getting there. Last week, it declined 4.9% to $12.49 on news that America’s already overflowing natural gas inventory grew even more due to the weak economy. Low demand, snappy production at both conventional and unconventional sources such as shale, and mild weather have all conspired to send inventories to the moon. The latest build puts America’s gas in storage at 3.152 trillion cubic feet, about 20% above its five-year average.

Some analysts are worried that we’ll suffer a complete price collapse before recovery, an event that could see UNG fall well below $10. If storage space runs out — as it’s in danger of doing in many places, such as East Texas — prices will have to sink to force shut-ins and completion deferrals. That kind of talk is common at bottoms, though, so let’s first keep an eye on UNG $12 and then think harder if/when we’re below it.

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