Trade of the Day: United States Natural Gas Fund (UNG)

by John Jagerson and Wade Hansen | February 26, 2014 9:51 am

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[1]). 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[2] in February as hot money jumps out of the market and temperatures start to rise. We expect that trend to continue.

Get our trade recommendation for playing this trend here.

Recommendation

Our view is that natural gas prices are inflated by hot money and will decline as the weather improves. We recommend a short position in UNG with a near term target of $20 per share. The risks to this trade should be fairly obvious. If the weather is colder than expected through mid-March, prices will likely remain stable or even rise. However, that means that the weather must actually worsen compared to expectations. Just being ‘colder than normal’ through March won’t be enough to keep prices high because unusually cold weather is already priced into the market.

From a technical perspective, we like the current setup on UNG and expect that if prices fall, they will likely decline to at least $20 per share where there is some underlying support. As you can see in the chart below, the recent highs on UNG correspond to lower highs on the Commodity Channel Index (CCI) forming a bearish divergence. This indicator does a good job at identifying temporary overbought conditions and accurately predicted the decline in natural gas this same time last year as well.
natural gas[3]

The timing of our recommendation was triggered by a bearish engulfing pattern that completed on February 24th and was confirmed on the 25th. There is little doubt that the stock will be volatile as it drops so stop losses against a short position should be generous. Alternatively, investors may look at the May/June puts for access to additional leverage and flexibility.

The natural gas market is news driven so each week on Thursday’s investors should pay attention to the inventory numbers released by the Department of Energy through the Energy Information Administration. These numbers are released an hour after the stock market opens in New York. If inventories rise or just decline less than expected, investors should rush for the doors and prices could reach our objective very quickly.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader[4], a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here[5].

Follow John Jagerson[6] and Wade Hansen[7] at Google+!

Endnotes:

  1. UNG: http://studio-5.financialcontent.com/investplace/quote?Symbol=UNG
  2. volatility has been on the rise: https://investorplace.com/2014/02/kinder-morgan-kinder-morgan-partners-kinder-morgan-energy/
  3. [Image]: https://investorplace.com/wp-content/uploads/2014/02/UNG-22614.png
  4. SlingShot Trader: http://slingshot-trader.investorplace.com/index.html
  5. by clicking here: https://order.investorplace.com/?sid=QP7117
  6. John Jagerson: https://plus.google.com/115711248746858558308?rel=author
  7. Wade Hansen: https://plus.google.com/108450692850544646698?rel=author

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