As you can see in the following chart, the iPath Series B Bloomberg Natural Gas Subindex Total Return ETN (GAZ) has suffered this year, in line with an overall selloff in the price of natural gas.
While these returns have been challenged, I believe that a turnaround is in store. Specifically, I believe that over the coming months, we will see GAZ reverse much of its decline as natural gas rises.
Natural Gas Markets
To start this piece off, let’s take a deep dive into the natural gas balance. Put simply, to understand where natural gas is likely headed through time, it makes a lot of sense to start with an understanding of where gas fundamentals currently stand. As you can see in the following chart, much of this year has seen gas inventories climbing against the 5-year average.
What the above chart shows is that throughout this year, we have consistently seen natural gas inventories gaining against seasonal benchmarks like the 5-year average and the figures from the prior year. This essentially means that bearish fundamentals have dominated in the form of poor heating demand this winter and poor commercial demand as a result of the spreading coronavirus.
If we were to stop with a simple look at the 5-year range, we would be left with a generally gloomy outlook on natural gas: stocks are rising and therefore prices should be (and have been) falling. However, when we turn the data on its head and look at the change in stocks, a different picture emerges.
This chart shows the rate of change of natural gas inventories throughout this year. Similar to the prior chart, much of the year is bearish with inventories gaining at faster paces than the typical rate for the year. However, what is dissimilar to the prior chart is that over the past 5-6 weeks, we have seen an unusual decoupling from the trend which has dominated this year in that gas inventory changes are starting to tighten against the 5-year average.
What this basically means is that while inventories have certainly been bearish this year, there’s been a slow, but steady change at work over the past month and a half or so which is indicative of fundamental change. There are two simple, yet important, reasons for this change. The first of these reasons is the weather. Put simply, the weather is very hot.
The above chart shows a consistent message throughout all of the major demand centers for natural gas – we are likely to continue to see very strong demand for cooling over the next few months. This cooling demand will result in another record-breaking gas demand year.
The largest driver of demand during the summer tends to be gas burn for electric generation associated with cooling. Not only is this the case, but gas demand has continued to supplant coal as the primary form of generation.
This essentially means that since the weather is likely going to be quite hot for the duration of summer and since gas demand continues to grow, we are almost certainly going to see gas inventories continue to contract against the 5-year average pace of builds.
Not only is gas demand likely going to be quite bullish, but also production is set to seriously decline as producers have trimmed the rig count substantially.
As you can see in the above chart, drilling activity continues to plummet with the total gas rig count dropping by over half in the last year. As you can also see in the above chart, declines in rig count are only arrested by sustained rallies in price (as was the case in 2016). Put simply, this decline in rig count is likely one of the most significant bullish factors on the balance.
In its latest Short-Term Energy Outlook, the EIA has provided the following chart to capture the decline in gas production.
What this chart shows is that the EIA expects production to be significantly reduced through 2021 due to the ongoing decline in drilling activity. This will likely lead to a much tighter balance, with the EIA calling for a gradual contraction throughout 2021 against the 5-year range.
And the key tie-in here for GAZ traders is this: as inventories contract versus the prior year numbers, there’s a very clear trend of rising prices seen in the data.
What the above chart shows is that there’s a very clear relationship between changes in inventories and changes in price. If you can call the direction of inventories over the next year on a seasonally-adjusted basis, then you have a very good chance of being able to call the direction of price changes over that same timeframe.
Given that production is declining and summer weather is very hot (and set to remain hot), I anticipate that the current trend of inventory changes contracting against the 5-year average will likely continue. As this continues, the price of gas will likely continue to increase which will result in higher prices and stronger returns to GAZ. In other words, from a fundamental perspective, it’s a great time to buy GAZ.
Prior to moving on from this piece, we need to say a quick word about GAZ’s methodology. GAZ is a fairly straightforward ETN in that it is tracking an index which offers second-month natural gas futures exposure.
The basic idea behind why GAZ is targeting second-month instead of front-month futures exposure is the problem of roll yield. Here’s the entire problem of roll yield as it relates to natural gas in a single chart.
This chart takes the last 10 years of data for natural gas and averages the differential in price between various futures contracts and the spot price or other futures. There are a few very clear relationships present in the data.
- Natural gas futures are on average priced above the spot level of gas – and this magnitude of difference of price tends to decrease the further back along the curve you look (a market state called “contango”)
- During a typical month, the difference between futures contracts tends to contract somewhat with the front contract bearing the brunt of the contraction
- The further out along the curve you hold, the less you see your futures holding contract versus the spot during a typical month
If you understood these past few bullet points, then you’ve captured the key problem of roll yield. Gas futures are almost always in contango (priced above the spot price) and this difference will eventually narrow to be basically zero at time of expiry of any specific contract. Since the front contract is expiring near the end of the month, any remaining contango or backwardation left in the price will be erased by the end of the month. However, the further out along the curve you hold, the less of a degree to which contango impacts your returns.
Popular ETFs like UNG are holding the front month contract and are suffering from roll yield while GAZ is holding the second month, and is able to greatly reduce it.
For this reason, I believe that GAZ makes for a strong addition to a portfolio. However, liquidity on GAZ is quite strained due to low volume. If you are an active trader, GAZ will not be a viable option for you at this time. However, if you are interested in capturing the seasonal change in prices over the next several months, then GAZ is a sound trade – but I suggest working limit orders on entry and exit to avoid poor prices.
Natural gas markets have tanked this year due to very poor demand in the face of climbing production. Both supply and demand variables strongly suggest that the balance is swinging into the bullish side which will likely drive GAZ higher. GAZ tracks second-month futures which allows it to greatly reduce roll yield impacts.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.