Friday, August 21, 2009

Natural Gas Deconstructed

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If you think logically, what is happening in the natural gas market will be difficult for you to understand. Markets actually always act rationally however, if you have all the facts available. When they don't seem to be doing so, it is because there is additional information that needs to be considered in order to fully understand what is taking place. In these circumstances you need to think about what could be taking place behind the scenes that could explain what is going on.

The natural gas storage report was released yesterday and it was bullish. Storage went up 52 BCFs and expectations were they would go up 55 BCFs. Natural gas has been declining for the last 11 days and is a heavily shorted market. So did it go up on bullish news? No, it sold off! The near term futures contract closed at $2.95. This in and of itself makes absolutely no sense and defies all rules in how markets operate. Even more surprising is that the cost of production for natural gas in the U.S. is somewhere around $4 to $5 depending on the source. It was already noted two months ago that 50% of U.S. gas wells had already been shut down because of low prices. Production should be close to collapse at this point.

The natural gas futures market is also in extreme contango (distant future prices much higher than the current futures contract), certainly the most extreme of any market in recent history. And the contango is getting even worse. The average price for natural gas futures between November and March is $5.32. Moreover, the oil/natural gas price ratio went over 24 yesterday. It peaked around 22 in 1990. This is also an historical extreme. When something gets way above (or below) its long term average, it invariably reverts back to the mean over time.

So who's making money off of this? This statement, which I found in an article for futures traders explains it all: "Traders on the future market are able to lock in the difference of over $2 per MMBTUs and cover their risk exposure by storing supplies until next winter." This is a particular boon to the large users of natural gas and these are the people profiting handsomely from the seemingly irrational behavior in the market. Furthermore, all of this has been made possible because of the CFTC (Commodity Futures Trading Commission), the government regulatory body which is supposed to be keeping the markets honest (and is doing as good a job as the proverbial fox guarding the hen house).

The CFTC announced in June they were planning on reigning in speculation in the market and have been holding hearings this summer. They specifically targeted the UNG ETF as a major source of speculation, even though it is a passive investment vehicle that only buys more natural gas futures in response to investor demand. UNG is also an investment vehicle used by small investors. Along with the SEC, which prevented UNG from issuing news shares for awhile and functioning as an ETF should, the CFTC has tried to cripple UNG's operations. This has allowed the big users of the commodity to drive near term natural gas prices to theoretically impossible levels - and make a killing. Like the SEC and its handling of $65 billion Ponzi Schemer Bernie Madoff (who was investigated several times over a many year period, but no dishonest behavior was ever found), the CFTC hears no evil and sees no evil when it comes to the big players.

As mentioned in yesterday's blog, there is an alternative to UNG. The ETN GAZ also represents the price of natural gas. While UNG lost 50 cents yesterday, GAZ was up 81 cents at one point, although it closed up only 16 cents. The trading volume on GAZ yesterday was enormous reaching almost 17 times the 200-day average. It looked like investors were dumping UNG to buy GAZ, which as an ETN is not affected by the CFTC's investigations. In theory, an ETF and ETN investing in the same commodity should move not only with the commodity, but by the same percentage amount. GAZ actually went up (and by a lot at one point) when natural gas futures were selling off and UNG was down. Just another indication that all rules of reality have temporarily been suspended in the natural gas market.

NEXT: U.S. Dollar, Stocks, Bernanke and Natural Gas

Daryl Montgomery
Organizer,New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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