As you can see in the following chart, the iPath Series B Bloomberg Natural Gas Subindex Total Return ETN (GAZ) is on a hot streak with shares reversing much of the year’s decline over the past week.
It is my belief that we are currently at a turning point in gas fundamentals and price. Specifically, I believe that while GAZ is likely to fall over the next few days due to mean reversion, over the next few quarters an uptrend in price will continue.
Natural Gas Fundamentals
As you can see in the following chart, gas inventories have actually been brushing against 5-year highs over the past few weeks.
While investors may see the above chart and think that fundamentals are bearish, I believe we need to look deeper at the data. Specifically, my favored approach is to simply examine the rate of change of weekly inventory figures.
Seen from this perspective, the numbers look quite different. While inventories are building, the pace of builds has continued to shrink versus the 5-year average with all but 1 week over the last two months seeing figures either at the 5-year average or below it. The last week witnessed the smallest build as compared to the 5 year average over the past few months.
Put simply, this is actually quite bullish. The reason why this is the case is that natural gas fundamentals by nature are fairly cyclic, so we need to take out the cyclical component in the data to figure out what is actually happening that is normal or abnormal. In this case, inventories are building at slower and slower rates which means that supply is unable to keep up with demand at this point. Let’s dig in to see why this is the case.
First off, the clearest reason why we are seeing inventories weaken is production losses.
As you can see, we are witnessing very large declines in gas production across the productive regions. Seen from another perspective, we are well into year-over-year declines in most areas.
It is very important to study history during these moments. Falling prices cause declines in production, but declines in production also tend to presage rises in price. For example, in the prior chart you can see that the last time we witnessed broad-based declines in gas production was during the middle part of 2016. Here’s what happened to the price of natural gas during this time period.
Put simply, decline in production is one of the fastest ways to fix a low price environment for natural gas. We are witnessing a historic collapse in drilling activity which is leading to plummeting production and historically speaking, plummeting production tends to be followed by rising gas prices.
I believe that this relationship is set to continue. I view the declines in production as a long-term situation which will be in place until gas prices have sufficiently corrected to the upside. However, as a check on my analysis, here is the EIA’s Short-Term Energy Outlook data.
What this chart shows is pretty clear: gas production is expected to remain weak through at least 2021. From a balance perspective, the EIA sees inventories continuing to weaken against the 5-year average through at least next year.
Put simply, these fundamentals are quite bullish in that they show that diminished supply is set to outpace any weaknesses in demand which will likely result in rising prices. I believe the recent surge in gas price was reflecting a market which is starting to price this in. I’m somewhat bearish gas over the next week or so based on the fact that markets normally don’t move in straight lines and you need trading and churning somewhat for a healthy trend to emerge. But over the next few quarters I am quite bullish gas because of the decline in production.
When trading natural gas ETPs, it’s important to separate your fundamental view from the view you hold on any specific ETN or ETF. The reason why it’s important to hold this nuanced perspective is that there are several different gas ETPs which offer materially different methods of exposure that can result in dramatic differences in performance through time.
In the case of GAZ, it is actually a somewhat unique ETP in that it is tracking the Series B Bloomberg Natural Gas Subindex. This index is obviously provided by Bloomberg, but what is not obvious is that it is giving exposure to gas futures in a unique way: when it comes time to roll exposure, it shifts out to the second-month natural gas futures contract and then holds this contract for two months before repeating the process.
The reason why this subtle nuance is important to note is contained in the following chart.
What this chart shows is the average differential between the first and second-month natural gas futures contract and the spot price of gas, grouped by the number of trading days until expiry of the front contract. What this data shows is a very clear relationship.
- On average, gas futures are priced above the spot level of gas
- On average, the differential between gas futures and the spot level of gas narrows during a given month with the front contract falling the most heading into expiry
This relationship is critical to understand because it essentially can translate into sizable losses for gas ETPs. For example, if you look at the front-month contract in the above chart, it is dropping by about 1.3% per month as it approaches the front. This tangibly means that if you were holding only the front futures contract, you would have lost about 16% per year of value simply through the convergence of futures into spot.
This is why GAZ represents a strong winning proposition: by holding exposure into the second-month futures contract for about half of the time, it is greatly reducing the losses associated with roll yield (the convergence of futures to spot). For this reason, I believe that investors looking to trade natural gas should consider doing so through the GAZ ETP.
The market is waking up to the bullish gas fundamentals as seen by a strong rally in the price of natural gas. Gas fundamentals are likely to remain bullish through 2021 due to declining production. GAZ is a strong ETP for trading natural gas in that its rolling methodology minimizes roll yield.
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.