Until recently, natural gas was almost exclusively traded in the futures market. However, the introduction of futures-backed ETFs have made it possible for more individual investors to access this market than ever before. This has been a mixed blessing. Theoretically, it means investors can diversify in new ways, which would be a good thing. However, these ETFs are inefficient and have increased the effect of so-called “hot money” that can lead to big swings in price.
Traders who chase returns and get in and out of a market very quickly are called “hot money”. It’s not unethical to be a short term trader like this and many of them are very profitable. However, these traders tend to move quickly in and out of an asset or market en masse and can contribute to extreme levels of volatility. Hot money is currently very active in the natural gas market and there are a lot of signs suggesting that they are ready to pull out.
Investors have access to natural gas futures through ETFs like the United States Natural Gas Fund (UNG). This fund has become very popular as a trading instrument but has also contributed to the hot money problem in the natural gas futures market. As investors move in and out of UNG very quickly futures have to be traded by the fund, which is then added to the monthly ‘roll’ that the fund has to execute as older futures expire. That increases trading volume and volatility in the market.
In addition to the problems of hot money, natural gas has not had an easy time since the energy bubble popped in 2008. New drilling techniques in the U.S. (think “fracking”) have made it possible to extract natural gas at higher quantities less expensively. However, while supply has increased and become more efficient, economic growth has not lead to a reciprocal increase in demand. In the chart below, you can see that natural gas prices as measured by UNG are a little less than 5% of their price in 2008.
Don’t be misled by the share price in 2008. Although the percentage decline is accurate, the high price is the result of adjustments after reverse stock splits. UNG also suffers from structural problems that make its long-term losses much more severe than natural gas futures themselves. The futures are only down 70% from their highs.
Recently, the cold weather and a moderate increase in demand has led to a very fast rally in natural gas prices. UNG jumped from $17 to $28 per share since November, however, volatility has been on the rise in February as hot money jumps out of the market and temperatures start to rise. We expect that trend to continue.