KOLD - KOLD: A Speculative Short Term Tool

2023-10-16 22:10:52 ET

Summary

• The ProShares UltraShort Bloomberg Natural Gas ETF aims to provide investors with -2x daily performance of the Bloomberg Natural Gas Subindex.
• The fund has taken advantage of the fall in natural gas prices in the U.S. this year, with a 70% gain.
• KOLD is a highly speculative tool with a 122% annualized volatility, and it is not recommended for buy and hold strategies.
• We believe we have seen a bottoming pattern in Natural Gas, with a bullish view on prices into the year-end.

Thesis

The ProShares UltraShort Bloomberg Natural Gas ETF ( KOLD ) is a commodities exchange traded fund. The vehicle falls in the leveraged products category, aiming to provide investors with the -2x daily performance of U.S. traded Natural Gas:

ProShares UltraShort Bloomberg Natural Gas seeks daily investment results, before fees and expenses, that correspond to two times the inverse (-2x) of the daily performance of the Bloomberg Natural Gas Subindex, a single commodity subindex of the Bloomberg CI composed of futures contracts on Natural Gas. It reflects the return of underlying commodity futures price movements only and is quoted in USD.

The fund has taken advantage of the fall in natural gas prices in the U.S. this year:

KOLD is up roughly +70% year to date, while the United States Natural Gas ETF ( UNG ) is down -47%. A linear -2x performance would have yielded 2 x 47%, i.e. 94%, but KOLD only replicates the daily performances, hence the beta slippage:

Beta slippage is a multi-day tracking inefficiency found in leveraged funds. Leveraged funds must rebalance over a predetermined time frame. For example a daily leveraged fund rebalances at the market close each day. This means the price movements are calculated on a percentage basis for that day and that day only. Due to rebalancing, the daily leveraged fund does not track true to its underlying index over a multi-day period. This structural tracking inefficiency caused by the leveraged funds need to rebalance is defined as beta slippage

KOLD is a highly speculative tool

As per the FINRA definition , KOLD is a 'geared' product with a unique set of risk factors:

Leveraged and inverse—often collectively referred to as "geared"—ETPs don’t work the same way as simpler one-to-one tracking ETPs. These are complex investments that come with a unique set of risks.

KOLD is a leveraged short position on U.S. natural gas, an asset class which on its own is extremely volatile. Using UNG as a proxy for a long position in U.S. natural gas, we can observe an astounding 66.9% annualized volatility and a 55% standard deviation:

These figures are courtesy of the Seeking Alpha platform, and they can be found under the 'Risk' tab.

When an instrument layers volatility on top of volatility, you get a result that is a pure speculative tool:

KOLD has a jaw-dropping 122% annualized volatility, and a 142% standard deviation. As a reminder, the S&P 500 has a 16% annualized volatility currently.

KOLD falls squarely in the short term speculative tools box, and we firmly believe a retail investor should actually not utilize such an instrument outside of daily capital efficient hedging activities. KOLD is NOT a buy and hold instrument. A picture is worth a thousand words in respect to this topic:

The fund has posted a -92% total return since 2019, although it is up substantially in 2023.

KOLD Holdings

The fund is currently short January 2024 natural gas futures:

Futures are an asset class which is not balance sheet intensive, which translates into the fund being able to achieve its objective by only posting an initial margin amount to short front end futures contracts.

Where is the price of natural gas going?

As mentioned above, KOLD is a leveraged take on natural gas prices, obtained via shorting futures. If U.S. natural gas prices go down, KOLD posts positive returns. Conversely, if natural gas prices are on an uptrend KOLD tends to post significant loses.

We are of the opinion that we have witnessed a bottoming process in natural gas prices:

After a significant rally in 2021 and 2022, natural gas prices came back to test the long term support at $2 /MMbtu. In fact both WTI oil and natural gas in the U.S. sold off in the first half of the year due to seasonal factors and the expectations for a recession in the U.S.

From a technical standpoint, we are seeing a bullish 'cup and handle' pattern:

For investors not familiar with this technical pattern, please see the Investopedia take on it:

A cup and handle price pattern on a security's price chart is a technical indicator that resembles a cup with a handle, where the cup is in the shape of a "u" and the handle has a slight downward drift. The cup and handle is considered a bullish signal, with the right-hand side of the pattern typically experiencing lower trading volume. A profit target is determined by measuring the distance between the bottom of the cup and the pattern’s breakout level and extending that distance upward from the breakout.

The confirmation of this pattern would imply a $3.4 MMbtu price for U.S. natural gas, representing the difference between the bottom of the 'cup' and the level where the breakout occurred. That is another 8% for upside, which translates into a -16% price move for KOLD, all else equal.

Long term Natural Gas dynamics

The long term U.S. natural gas price dynamics are very much dependent on the European market:

The above chart presents the average natural gas price in Europe, where it is currently trading at $11.55 MMBtu, almost 4x the U.S. pricing. We can see a massive spike in pricing to $60 MMBtu after the start of the Russia/Ukraine conflict, levels which have now normalized. The difference however is staggering.

We expect this differential to narrow in the next few years, with U.S. prices set to increase as more LNG facilities come on-line:

LNG stands for 'Liquefied Natural Gas', and is produced by purifying natural gas and super-cooling it to turn it into a liquid. During the process known as liquefaction, natural gas is cooled, removing most of the extraneous compounds found in the fuel. LNG is easily transportable, and represents the means of accessing the European market for US producers.

Europe is now the main export market for U.S. producers, as per the EIA:

Europe became the primary destination for U.S. LNG exports in 2022, accounting for 64% (6.8 Bcf/d) of total exports. Four countries—France, the U.K., Spain, and the Netherlands—accounted for a combined 74% (5.0 Bcf/d) of U.S. LNG exports to Europe.

As more LNG terminals come on-line, expect this trend to continue, with the results being higher U.S. prices and less volatile European ones. This trend is extremely negative for KOLD, with a structural bull market now developing for natural gas.

Conclusion

KOLD is an exchange traded fund. The vehicle aims to offer the inverse 2x daily performance of U.S. traded natural gas via short futures positions. If natural gas goes down in value, KOLD gains. The fund has done well this year, with a 70% gain. Despite its large YTD gains, the vehicle is down -92% since 2019, highlighting its leveraged structure.

KOLD is not a buy and hold instrument, but a speculative short term trading tool. With an astounding 122% annualized volatility, this instrument is only suitable for well seasoned short term traders. Natural gas is a volatile asset class in itself, but adding leverage on top gives it a magnified dynamic.

We are of the belief we have seen a bottoming pattern in natural gas occurring, with the rest of the year on a bullish path, and the next target price for natural gas at $3.4/MMbtu. This level would represent a -16% performance for KOLD from today's price point. We are a Sell for KOLD and do not think retail investors should engage this extremely volatile name outside of day-trading activities.

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