Summary
- GAZ, an ETN, and UNG, an ETF, provide exposure to natural gas, with the latter being much more popular as seen by the number of followers on SA.
- Both should continue to be on a downtrend as in addition to demand-supply factors there is also storage to consider, both in Europe and the U.S.
- I back my statements through EIA charts, predictions by commodity traders, and research by a consultancy firm.
- Adding to demand/supply and storage, there is also the lack of European gasification plants to consider, which could break the downward trend in commodity prices, but only after the winter.
- In the meantime, imagine fleets of LNG containers as illustrated by the picture below crossing the Atlantic to supply Europe to the point of creating a glut.
Those who had hoped to profit from a rise in the price of natural gas following Russia initially reducing and then completely cutting natural gas supplies to Europe were in for a shock when the prices of natural gas started tumbling in September. As a result, the iPath Bloomberg Natural Gas SubTR ETR B ( GAZ ) moved down to about $30, with the United States Natural Gas ETF ( UNG ) also following a similar trend as shown in the charts below. However, they differ in actual performance as I will show later.
These downtrends are surprising, especially in the midst of the energy crisis, and with the winter you may anticipate a rise in commodity prices, as gas consumption for home heating purposes should skyrocket while Europe has to compensate for the roughly 50 billion cubic meters it used to import from Russia.
However, as I will show in this thesis, natural gas prices should be pressured downward, at least till the first quarter of 2023. The reason is that it is not so simple to predict prices in the energy supply-demand complex, and, I start with the European landscape.
Reshaping of the European Energy Landscape
First, the explanation for the slide in gas spot price (chart below) is explained by European Union countries working frantically to reduce dependence on Russia since the beginning of this year, namely by shifting from natural gas (in gaseous form) to LNG or liquefied natural gas. The reason is that LNG can be transported in ocean tankers potentially from all corners of the world, thereby reducing dependence on any given exporting country together with the associated gas pipeline.
Thus, European LNG imports increased by 60% in the first half of 2022, allowing the filling up of gas reserves to near saturation. This explains why Henry Hub prices increased rapidly till around June as seen in the chart below.
Subsequently, in October, Europe did not fully enter the cold winter period implying that natural gas consumption has not yet started its usual cycle. At the same time, there was an overflow of gas at the end of October, resulting in storages being 90%-100% full in countries throughout the old continent.
Moreover, industries that had reduced production or shifted from natural gas to diesel or even coal could not take advantage of the drop in spot prices as they needed time to ramp up. This resulted in demand not being sustained, while with the stocks already being full, the additional inflows (through tankers as seen in the above picture) only resulted in boosting supply.
For this matter, according to CNBC, there were over 60 tankers waiting on the shores of Europe to discharge their cargo of LNG at the end of October. Now, this is the reason why commodity traders at Goldman Sachs ( GS ) expect the Dutch TTF Gas for Dec 2022, which is a European benchmark, to fall to 85 euros per megawatt hour in the first quarter of 2023, down from the peak of 340 euro attained on August 25.
The Supply-Demand Equation Expanded to the U.S.
Thus, it is the speed with which Europe is reshaping its energy landscape to move away from Russia which has been detrimental to prices. However, another factor that has played a role in determining prices is production at the world's largest producer of natural gas, the United States.
In this respect, in contrast to crude oil, natural gas production in the U.S. has already surpassed its pre-Covid highs as seen in the chart below.
As a result, the prices have been trending downward in North America as seen in the chart below, but before that, they were at record highs or three times their pre-Covid levels as shown in the chart below. Now, these high prices have contributed to the high consumer price index by raising the amount of money people have to pay for heating their homes resulting in inflated bills.
This means that high energy prices have contributed to high inflation, in turn prompting the Fed to raise interest rates. This in turn had the unintended consequence of slowing down the economy and reducing demand, which clouds the prospects for a rise in natural gas prices. At the same time, the Chinese authorities have reiterated support for their highly restrictive Covid zero policy which remains unfavorable for demand. By contrast, there has been some relaxation of airline travel measures, but planes do not consume natural gas, isn't it?
GAZ's Prospects and Comparison with UNG
In these conditions, the outlook for GAZ which tracks the Bloomberg Natural Gas Subindex Total Return does not appear bright. For investors, GAZ is an ETN or Exchange Traded Note, riskier than an ETF which most of us are familiar with, as it makes use of unsecured debt securities which have limited principal protection. Thus, any payment (at maturity or upon redemption) to be made by the ETN, depends on the ability of the issuer, in this case, Barclays PLC ( BCS ) to satisfy its obligations as they become due. As such, it involves more risks and may be unsuitable for certain investors.
Looking further, the ETN charges fees of only 0.45%, and despite, its recent downturn has still managed to deliver year-to-date gains of over 69%. More importantly, a comparison of its one-year performance with the Henry Hub spot prices as shown in the chart below reveals that it has outperformed the latter by a hefty 40% margin.
Coming back to the comparison with UNG, the ETN has outperformed by more than 2.5%. The reason for this has to do with rolling exposure as explained in detail in the thesis entitled "Buy The Pull Back In GAZ".
Looking deeper into the thesis, the author QuandaryFX argues that the difference between GAZ and UNG is because the ETF holds and rolls over (shifts from a short-term to a longer-term contract) in the front month whereas the iPath ETN holds the second-month contract. As a result, GAZ experiences fewer losses from the "convergence" effect.
Now, looking at convergence , this is all about the difference between the price of a futures contract, (as held by UNG's or GAZ's underlying indices), and the underlying cash commodity, with the two converging as the delivery date approaches.
Thus, in addition to purely pricing factors, convergence together with the fact that GAZ makes use of a different rolling-over mechanism makes it more appealing as a tool to invest in natural gas. I confirmed this by looking at the price performances and in this respect, GAZ is superior over the long term as evidenced by its better performance (table below). Moreover, it provides better shielding against volatility, as illustrated by its lower one-month underperformance.
GAZ also charges lower fees, but as shown by its AUM (assets under management) of much less than $100 million and risks inherited as an ETN, it is not suitable for all investors.
Conclusion
As we head into winter, a period that is normally characterized by a peak in demand for natural gas, the question is what could be the impact on natural gas prices over 2023?
For this purpose, the consumption chart below shows a peak of U.S. consumption to occur in January of each year since 2002. These peaks vary in magnitude but have been regularly showing up even during periods of economic slowdowns and amid global warming.
However, again dealing with the dynamism and complexity of the natural gas market, the storage factor creates an element of unpredictability. In this case, according to research by McKinsey , after several injections in September and October this year, U.S. inventories are only 5% below their five-year average. This means that the downward pressure on GAZ and UNG should continue.
Shifting back to Europe, there is a need to add gasification plants to convert LNG disembarked from tankers back to gas form as well as pipelines to expedite them to distribution centers. Now, mostly dependent on Russian gas coming through pipelines from the East, Europe lacks gasification infrastructure at its ports and this may cause a bottleneck in the flow of gas to storage tanks as winter utilization depletes stocks in the December-February period. With storage facilities not being replenished rapidly, this could reduce supply, thereby causing an upside in the price of natural gas prices. Thus, GAZ can again flirt with the $35 level, which was reached at the beginning of October, but again, there is U.S. production to consider as well as transportation of the commodity across America.
Finally, elaborating on the complexity of demand-supply, and storage in the natural gas industry, this thesis has made the case for a downtrend in GAZ at least up to the first quarter of 2023, which will be subsequently followed by an uptrend. However, bear in mind that there are many factors at play here which means that uncertainty will reign.
For further details see:
GAZ: Downtrend Should Continue But Still Better Than UNG