UNG - FCG: Buy The Bottom In Natural Gas Prices

2023-12-21 22:06:32 ET

Summary

• The First Trust Natural Gas ETF holds a portfolio of Oil & Gas equities, reflecting both the profits made from selling and transporting natural gas.
• The companies in the FCG portfolio have improved their balance sheets post-Covid, reducing debt and increasing liquidity.
• Natural gas prices have dropped significantly in 2023, with the UNG futures ETF down over -66%.
• With the development of more LNG terminals, prices are expected to structurally increase in the future, making FCG an attractive investment.

Thesis

The First Trust Natural Gas ETF ( FCG ) is an equities exchange traded fund. Despite its nomenclature which might give the false impression the fund invests in natural gas futures, the vehicle in fact holds a portfolio of Oil & Gas equities. FCG seeks investment results that correspond generally to the price and yield of an equity index called the ISE-Revere Natural Gas™ Index. The index contains a mix of transportation entities and exploration and production companies. Through its composition the fund is a reflection of both the profits made out of selling natural gas as well as transporting it.

Traditionally both the transporter and E&P companies had two main risks associated with their business models, namely the price of natural gas and secondly the structuring of the balance sheet. The first risk is fairly straight forward, with higher natural gas prices make it more profitable to extract it and to transport it to a certain extent. The second risk factor experienced a great reset during the Covid crisis, with many of the entities present in the portfolio suffering 'near death' experiences:

Antero Resources ( AR ) is a natural gas E&P company, and as we can see from the above graph courtesy of YCharts, the entity almost went bankrupt during Covid. On one hand we had lower natural gas prices which drove profitability lower, but the dire situation for AR was mostly driven by its balance sheet during that period. The company had many near term debt maturities and a poor liquidity position in terms of its revolver. However, Covid provided a very tough lesson for many of these entities, who understood the importance of managing a balance sheet in a conservative fashion and the necessity to be ready for another down cycle. In today's world, most of the companies in the FCG portfolio have very healthy balance sheet, with debt termed out during the 2020/2021 zero rates environment and with large revolving facilities with three to five years remaining maturities. Moreover, most of them significantly reduced their leverage towards 1x EBITDA, ensuring not only survival during today's down cycle, but actually robust equity prices.

Natural gas prices are back to square one

It has been a wild roller-coaster ride for natural gas prices in the past few years:

After being as high as $9/MMBtu during 2022, natural gas prices have come down to $2.43/MMBtu now, but more importantly they are down over -30% since October. Seasonality plays an important role, with a warmer than expected winder both in the US and Europe contributing to a lower than expected demand pattern:

Driven by the Russian/Ukrainian conflict, Europe has been very proactive about consumption as well as the sourcing of gas for its injection season. A very cold winder could have theoretically pushed the continent towards lack of resources for heating and its industry. Fortunately for Europeans, it has been the complete opposite. As we can see from the above graph, the EU storage is at a historical high, with most countries now looking at the best way to deal with higher cost purchases.

In the US, when looking at Henry Hub, we can see the spot price being back close to its long time support line of $2/MMBtu, which outside of Covid is a very well established technical and fundamental support. Why? Because fundamentally most producers break even from a profitability perspective when natural gas is in the mid-2s, so prolonged periods of natural gas at $2/MMBtu results in less inventory drilling and extraction. Cycles take a long time to play out, but historically that is the reason this level represents both a technical and fundamental support level.

FCG has done very well in 2023

Sporting a 3.4% yield, the fund has done very well in 2023 from a total return perspective, considering the absolute destruction in spot prices for natural gas:

The United States Natural Gas ( UNG ) ETF is an exchange traded fund using futures to provide the return of spot natural gas prices (readers can look on the Seeking Alpha platform for UNG specific articles), and the fund has been wrecked in 2023, down -66%. FCG on the other hand has been able to keep a positive performance, despite the collapse in prices for its main commodity. The reason? As explained in the 'Thesis' section, the components in FCG have done tremendously well in cleaning-up their balance sheets, thus the market is now pricing them on their forward, rather than an imminent demise. As long as the futures curve is upwards sloping, the market can see larger profits in the future that get discounted to the present, thus the price impact to the equity price is not as abrupt as investing in the outright commodity.

Buy low, sell high

In our opinion FCG is not a true buy and hold, but as many commodities funds, a cyclical play. A retail investor should follow the 'buy low, sell high' mantra by following the pricing in the main risk factor here, namely natural gas. Should you have bought FCG when natural gas prices were at all times high? No. Should you consider purchasing FCG now, when we are very close to historic support levels in natural gas prices? We think so. We are of the opinion that the energy transition will take many years to occur, and until then oil and gas will follow their cyclical patterns, with the added benefit to natural gas of LNG terminals. The development of LNG terminals will basically 'pull-up' natural gas spot prices in the US to match the higher levels in Europe and Asia:

If we look into the future, we can see capacity ramping up significantly after 2024, which will translate into higher profits for the components making up the FCG collateral. Said developments take time, and their progress is actually closely monitored by the spot market, which sometimes records outsized moves when delays are announced. However, higher export capacity will translate into higher prices on a more permanent basis.

The fund components are large Oil & Gas companies or transportation MLPs, which are set to benefit:

Conclusion

FCG is an exchange traded fund. The vehicle holds a portfolio of natural gas producers and transportation companies. The underlying entities have done a 180 in terms of restructuring their balance sheets post-Covid via debt reductions, refinancings and extensions. Fundamentally, all the portfolio companies are in much better shape than three years ago, which explains the robust fund performance in 2023 despite the -66% drop in natural gas prices as reflected in the UNG ETF.

With natural gas close to its historic support level of $2/MMBtu, retail investors should start considering investing in FCG. Natural gas prices are highly cyclical and volatile, but the development of LNG export facilities will provide structurally higher prices going forward. We feel today's low price environment for natural gas provides for a nice entry point into E&P producers and transportation companies as reflected by FCG.

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