The next big commodity play
Above is a graph of various commodity ETFs. The main ticker is UNG (United States Natural Gas Fund), a ETF which tracks prices of natural gas delivered at Henry Hub. OIL is the iPath Oil ETN. JJA is the iPath Agricultural Commodities ETN. JJM is the iPath Industrial Metals ETN. And, JJP is the iPath Precious Metals ETN. The chart displays the year-to-date performance of these various commodity indexes and it’s plainly obvious that one stands out among the others. Generally speaking, non-energy commodities have been on an upward trend since the beginning of the year and in fact would have provided mid-to-high teens returns just in the last few months! Even oil, though down precipitously in the first two months of the year, has rebounded swiftly to near break even year-to-date. Only one commodity seems to have lagged behind the rest – natural gas.
Natural gas prices have declined nearly 40% since the beginning of the year and have not at all responded to the recent bullishness in the markets. I’ve written before about the value of having oil exposure in your portfolio, but the same could be said of energy exposure in general. These types of commodities act as a hedge against inflation, a direct hedge against increasing energy costs taking a toll out of the businesses you’ve invested in, and prices are supported to some degree by near universal demand and constrained supply.
Natural gas, however, is fundamentally different from oil and this fundamental difference could explain its recent lag as well as give us insight on its potential to rebound swiftly and vigorously.
- Oil is a global market while natural gas is a domestic market. Oil can be easily transported on tankers and through pipelines whereas the transport of natural gas is significantly more difficult. As a result, demand for natural gas in the United States more strictly follows US industrial/residential demand.
- Natural gas is typically considered a backup to crude oil. Power plants typically have back up turbines powered on natural gas. In another example, the production of ethane for industrial uses is often determined via the price/value tradeoff of using natural gas or petroleum as a feedstock.
- Due to natural gas’ secondary nature as a feedstock/fuel, demand is considered seasonal. Temperature extremes (hot or cold) put extra stress on the energy grid and cause providers to flock to natural gas as a way to control costs in the face of rising demand for petroleum and to quickly scale output to meet demand. Similarly, increasing industrial utilization eventually drives producers to choose natural gas as a feedstock for their processes.
As the summer months and potential supply shocks due to hurricane season approach, the time is ripe for natural gas to begin catching up. In 2006, the Department of Energy published a statistical study of natural gas and oil prices between 1989 and 2005, it’s findings were consistent with what we expect from the above mentioned characteristics of natural gas. As a secondary substitute to petroleum, long term natural gas and oil prices move with significant correlation to one another. Natural gas prices, however, tend to lag large changes in oil prices and their correlation is muted when oil price changes are transitory as opposed to permanent.
If you’re thinking about making a play at natural gas, the key question to ask is whether or not the current rebound in oil is here to stay? More fundamentally, this is a question of how significant and how rapid the rebound in industrial production in the United States will be. I won’t portend to be a master of economic and business indicators or to have a crystal ball, but what I do know is that having the benefit of watching oil and other commodities, betting on natural gas is not a difficult leap at all.
Full disclosure: Author has no direct positions in any of the funds and commodities mentioned in this post. Author is long shares of LINE, an oil and gas MLP, and VLO, an oil refiner.
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