Near Term Outlook For Natural Gas ETFs Is Bearish

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September 15, 2013 10:43pm NYSE:DGAZ NYSE:FCG

natural gas2013 started off on a strong note for natural gas, one of the few solid performers in the natural resource world. But the commodity showed a sharp pullback in the last few months due

to the broad commodity sell-off trends and natural gas specific concerns such as excess supply and sluggish demand.

Latest EIA storage report 

The bearish trend was reflected in the latest EIA storage report – a key mover of the natural gas markets – in which supplies continued to build for the key fuel. Additions hit 58 bcf, following a 67 bcf injection the week before, pretty large numbers considering it is the heart of summer (read:Natural Gas ETFs Slide on Bearish Storage Report).

And while temperatures have begun to pick up in some parts of the Midwest and Northeast, the summer has been pretty mild overall. There have been a host of above-average supply injections as of late, and with an end to summer weather fast approaching, we could be in for more supply injections in the weeks ahead as well.

Additionally, natural gas stocks currently total 3,188 bcf, which is now slightly above the five year average.

Near Term Natural Gas Outlook

This trend is expected to spill over to the tail end of the summer, though there is some hope for hotter weather in key regions of the country. However, if these forecasts do not pan out, more people are unlikely to turn on air conditioning, thereby limiting electricity demand in the coming weeks.

Since roughly one-fourth of all U.S. electricity is generated via natural gas, a drop in electricity demand can have a huge impact on the usage of this energy source.

Furthermore, with natural gas futures usually in a state of contango, longer term bets on the commodity tend to be tough for the bulls. Longer dated futures are usually more expensive, so rolling over contracts can be difficult to do at a profit, once again favoring the bears.

Given this, along with the bearish inventory report and the possibility of mild weather, natural gas ETFs may fall further, extending the brutal trading pattern to the fall as well. This is especially true considering the magnitude of the supply injections of late, and the trend that is building for this metric (read: The Comprehensive Guide to Natural Gas ETFs).

In such a backdrop, any of the short natural gas ETF plays could be better options for investors who are bearish right now, given the supply/demand imbalance and the long history of natural gas weakness in the ETF world:

VelocityShares 3x Inverse Natural Gas ETN (DGAZ)

The ETN provides inverse (opposite) exposure to three times (300%) the daily performance of the S&P GSCI Natural Gas Index Excess Return plus returns from U.S. T-bills net of fees and expenses.

The note was launched in Feb 2012 and since then has been able to amass an asset base of only $40 million. The product is the high cost choice in the natural gas space, charging 165 bps in fees per year from investors.

Additionally, it has a relatively narrow bid/ask spread given its average daily volume of more than 800,000 shares so extra trading costs should be minimal.

ProShares UltraShort DJ-UBS Natural Gas Fund (KOLD)

The fund seeks to deliver twice (2x or 200%) the inverse return of the daily performance of the Dow Jones-UBS Natural Gas Subindex. Launched in Oct 2011, KOLD makes a profit when the gas price declines and is suitable for hedging purposes against the fall of natural gas(read: The Key Differences Between Natural Gas ETFs).

The product is illiquid and has about $18.9 million in AUM. It is expensive when compared to other geared options in the space, charging 95 bps in fees a year.

Bottom Line

Investors should note that since these products are extremely volatile, these are suitable only for traders. Additionally, the daily rebalancing – when combined with leverage – may cause these products to deviate significantly from the expected long-term performance figures.

Still, for ETF investors who are bearish on natural gas in the near term, any of the above products could make an interesting choice. Clearly, some are abandoning the commodity, so a near-term short could be intriguing for those with a high risk tolerance, and a belief that the “trend is your friend” in this corner of the investing world.

This article is brought to you courtesy of Eric Dutram.

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