On Monday this week I gave subscribers a trade idea for the winter–be long the US Natural Gas Fund ETF, symbol UNG-NYSE (closing $16.79 that day), and short the US Oil Fund, symbol USO (closing $56.07 that day).
Now don’t get incredulous that this trade idea is a straight up short oil. It’s just a bet that natgas does better than oil–especially until the middle of January, but quite possibly through the winter.
The reason I pick mid-January is because of COVID. I subscribe to a research service that has been uncannily accurate in giving pivot dates for the peak of the COVID waves–and the next one (says my guru) is mid-January.
This week, the trade has worked out. UNG-NYSE is down only pennies, but USO-NYSE is down $2.29/unit. And the reason oil fell this week: Europe starting to shut down again in several places due to COVID. I’ll explain it all in a bit more detail below, but the other side of the trade–long natgas–is a bit more fundamentally driven.
Only months ago, I never thought I would say this: The market is too bearish on natural gas.
Let that sink in for a minute…
I know what you are saying: Wait – how can that be? Natural gas prices are just under $5+ right now. Prices are higher than they have been in years.
How can this be bearish?
Well the focus is all on the front month contract. That is not the whole story.
Looking further out the curve, you can see the pessimism. It is called backwardation.
Backwardation means that the future price of each month out is less than the previous one.
Source: CME Group
The backwardation in natural gas right now is steep. While the prompt month (Dec 2021) is trading at $5.06, May 2022 is actually below $4.
The market is saying “sure, you might get your cold winter but it will end and prices are coming back down”.
It is that sort of pessimism that could give us a 20% on the United States Natural Gas Fund (UNG – NYSE) if gas even just stays at this level and the curve rolls out.
But I have one worry with this trade. The economy.
To hedge that bet, I am suggesting a pair trade – long UNG and short the United States Oil Fund (USO – NYSE). This is not a bet against oil–just that natgas does better than oil.
It Will Be A Tight Winter for Natgas
We are almost guaranteed a tight natural gas market this winter. It is going to be tight everywhere.
Unlike past tightness, this is not a North American phenomenon. We have a global shortage of natural gas.
That means two things.
- Gas is going to continue to be pulled out of the US market
- Speculation is going to remain high
These two factors are going to keep natural gas prices up. That alone, along with a normal winter, and the long UNG trade does well.
But the real upside comes from a cold weather spike. There is a real chance that we get a $10+/mcf handle on natural gas if there’s a prolonged cold snap.
Europe has already paved the way for speculators to drive up natural gas prices if the weather gets cold.
RIDING THE CURVE
Buying UNG, the natgas futures curve is working in our favor. UNG is a very simple product. Here is what the ETF owns:
UNG holds the prompt month natural gas future contract. Every month UNG rolls over that contract for the next month.
In contango, where the futures prices are higher than spot, this roll works against you. But with this kind of huge backwardation, the roll actually benefits UNG holders.
Every month the UNG fund managers are selling higher priced prompt month contracts and buying lower priced out-month contracts. It effectively is buying more natural gas each month.
Of course, by itself that does not make UNG a winner. If natural gas prices fall across the curve, you lose. But it does trim your losses on the way down.
The big win for UNG longs is twofold.
First, if the future curve is wrong, i.e. it is UNDER-estimating an early spring cold snap (think of the two Polar Vortex’s we had in a row a few years back–they were both late winter/early spring).
I estimate that if the April and May natural gas move up to the $5+ level (from the sub-$4 level they are suggesting now), that could cause a LARGE price spike in the ETF price for UNG.
Second, a big spike over the winter due to cold weather.
What Could Go Wrong??
I have one big worry about this trade.
You guessed weather didn’t you? Admit it. This is natural gas – the worry has to be weather.
No, not weather.
My biggest worry with this trade is the economy.
I know I’m going to get some pushback here. The stock market is within spitting distance of all-time highs.
How can the economy be anything but strong?
Yet the reality on the ground is telling a different story.
First, while equity markets soar, debt markets are telling us there is something wrong.
The yield curve is starting to flatten. The two-year yield has increased to 50 basis points from a little over 20 in the last few weeks while the 10-year yield has come down a few basis points.
The bond market is always smarter than the equity market. But you don’t just have to listen to the yield curve – the data is saying the same thing.
One of our favorite indicators is the GDP output gap.
Right now, the output gap is in overdrive. We are producing more goods and services than we should given the level of labor and materials available.
Source: Unit Economics
Typically, this sort of overheat is followed by a period of stagnation.
That is exactly what the Fed seems to be predicting. Three months ago, the Atlanta Fed—the most accurate branch of the Fed in all the USA—was predicting 3% growth in Q3. Then it dropped to 1.5%. Now it is 0.5%.
Source: Unit Economics
This does not make me a bear on the stock market. The factors driving many parts of the market right now are simply not that sensitive to an economic slowdown.
But it does give me pause on a long natural gas trade, because natural gas does move with the economy.
Which brings me to the short side of the trade – oil.
The oil short is simple. If economic activity slows, oil demand slows. With oil prices already printing above $80, there is plenty of downside in that scenario.
Crude oil always reacts more negatively to an economic slowdown than natural gas. That would be doubly the case this year if it is accompanied by cold weather.
Meanwhile the upside on oil if the economic slowdown thesis doesn’t play out is far more limited than natural gas.
Don’t Hold Your Breath On Supply
The other thing that you always have to worry about with natural gas is supply. But for the moment I think you can put those concerns aside.
There are just too many dis-incentivizes to increasing production right now.
First, back to the futures curve.
That backwardation is not encouraging more production. While front month economics look stellar, prices swoon out even a few months. If you bring on a new well now, you are doing it at $4 expectation, not $5.
As a producer you’ve been hit with years of disappointment. The price always comes down. The curve is just backing up what you already know.
There are other headwinds. Producers need to look environmentally friendly. They need to appease shareholders that are demanding a return of their cash.
In this kind of environment, you need a curve with a whole lot of optimism – not pessimism – to entice more drilling.
A Simple Bet
This is a pretty simple trade. I think natural gas has more upside and less downside than oil over the next 4-6 months.
I’m not saying that higher natural gas prices are a sure thing. That is exactly why I am not just going long UNG and calling it a day.
We have a front month gas contract that is a tad under $5. At that level, things could go wrong. But the most likely thing to go wrong – the economy – would go even more wrong for oil.
It’s a paired trade.
Ideally the best of all worlds is the next six months where natgas prices move up, and oil prices go down. But even a nice little move up of that natgas futures curve–as we step through winter– will hopefully create a spike to sell into.
But if we do have an economic downturn or a COVID resurgence, the USO short really gives this trade some juice.