HESM - FCG: Negative Alpha Ahead In Natural Gas

Summary

• Powell talked about inflation peaking out, particularly in the goods sector due to normalization of supply chains in the latest FOMC meeting.
• This gives rise to my bearish view on the natural gas industry, which can be played via the FCG ETF.
• Leading indicators point towards continued slowdown in industrial activity, which makes up more than 60% of natural gas usage.
• There is an evaporation of pricing tailwinds as Europe is expected to de-risk further from natural gas dependency.
• Technical analysis also points towards downward pressure in FCG, especially relative to the S&P 500, suggesting negative alpha.

Introduction

The markets seem to have turned optimistic after the recent FOMC meeting, which acknowledged a disinflation underway, particularly in the goods sector:

You see inflation now coming down because supply chains have been fixed, demand is shifting back to services, and shortages have been abated.

- Federal Chairman Jerome Powell in his February 1 FOMC speech

This statement prompts a supply-chain oriented investment idea in the First Trust Natural Gas ETF ( FCG ), which gives exposure to companies involved in the upstream (exploration and production) and midstream parts of the natural gas value chain. My analysis of leading volume indicators and drivers of future prices leads to a bearish outlook on FCG.

ETF Composition

Top 5 Holdings

The top 5 holdings include DCP Midstream ( DCP ), Hess Midstream ( HESM ), Western Midstream Partners ( WES ), ConocoPhillips ( COP ) and Occidental Petroleum Corporation ( OXY ).

Out of the 51 holdings in FCG, the top 5 holdings make only 22% of the overall ETF. Moreover, there is a rather even distribution among the top 5 holdings. This increases the quality of the ETF as it serves its purpose better; to give a broad exposure to an investment theme without undue outsized risk to any individual stock.

15.1% of overall exposure, that is 68% of the top 5 exposure is associated with the midstream part of the natural gas value chain. This suggests that FCG is not purely and directly linked to natural gas prices alone; volumes also are a key driver to consider.

For those new to the industry, my original article on another midstream O&G ETF, AMZA ( AMZA ) explains the structure of the value chain clearly.

Fundamental Drivers

As mentioned earlier, for the mid-stream natural gas companies, volumes are the main driver of the business. About 61.5% of natural gas is used in industrial activities and electric power generation:

This makes industrial activity indicators such as the manufacturing PMIs key leading indicators of production volumes.

For the upstream natural gas exploration and producing companies, in addition to volumes, the price of natural gas is a key driver. The US Henry Hub natural gas price futures is the industry standard for tracking natural gas prices.

Based on the analysis of these key drivers, I form a bearish fundamental thesis on FCG's future outlook:

Continued slowdown in industrial activity

The Institute of Supply Chain & Management's US Manufacturing PMIs printed 47.4 in January 2023, indicating further, accelerated contraction in industrial activity as the level is deeper down below 50. The New Orders print, which is a leading indicator of the overall PMI, showed a sharp decline from 45.1 in December 2022 to 42.5 in January 2023. This suggests further weakness ahead in industrial activity. By extension, for reasons discussed in the previous section, the weaker outlook for industrial activity paints a subdued outlook for natural gas volumes.

Evaporation of pricing tailwinds

Since July 2022 till January 2023, the Henry Hub natural gas futures prices have had a precipitous fall of almost 76%. This is driven mostly by a normalization of supply-side shocks that affected the industry last year due to the Russia-Ukraine war. A warmer European winter has led to gas storage buffers of more than 80% . Former UK government energy official Adam Bell notes that this has “bought Europe a year" to transition away from natural gas dependence. I anticipate the reduction in demand following from this to continue reducing prices and volumes, particularly among mid-stream companies. Market research firm IBISWorld supports this view as they forecast a 2.6% CAGR decline in US natural gas prices over the next 5 years.

Technical Analysis

If this is your first time reading a Hunting Alpha article using Technical Analysis, you may want to read this post , which explains how and why I read the charts the way I do, utilizing principles of Flow, Location and Trap.

Relative Read of FCG vs SPX 500

The relative chart of FCG vs S&P 500 ( SPY ) ( SPX ) shows the ratio price reacting off the monthly resistance and heading down toward monthly support, suggesting negative alpha continuation.

Standalone Read of FCG

The standalone chart of FCG shows a similar setup; strong reaction from the monthly resistance curbing the buyers' advance further. In a weak market, I would not be surprised if FCG returns back to the monthly support at $19.90.

Positioning

Leading indicators of industrial activity, which makes up the majority of natural gas consumption, are trending down. Commentary from European energy officials and specialist market research firms also point towards continued weakness in natural gas prices. Lastly, the technicals are also in alignment, suggesting a further move down, especially relative to the S&P500.

Therefore, I rate the FCG natural gas ETF a 'sell'.

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