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13 Aug 2019

NatGas Primer

Introduction

We shy away from directly trading commodities, futures and currency. We are not discriminating, just our experience that these are marvelous ways to lose more money faster than anything else we have tried.

However, there are some indirect ways of engaging that have merit. For Natural Gas that is UGAZ and DGAZ. We will discuss them in detail here and give an overview of the natural gas markets. The more you know, the better your trading performance.

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Background

Natural gas markets are interesting from a few vantage points. As we have more natural gas supply than demand during most parts of the year, gas storage plays a large part in seasonal price movement. While natural gas is fungible there are constraints on transportation that drive pricing.

Natural gas has historically been a regional commodity with small volumes of liquefied natural gas (LNG) being shipped outside the production region. This is changing as the technology has improved and the price differential is very large. The average price of gas in Chicago may be about $3.50 per thousand cubic feet (mcf). In Europe, Japan and China the price is more like $7.50/mcf.

As exports increase there will be changes to the underlying mechanics of pricing. For now, the cost of transport is such that LNG net back to the producer(sales price less transportation fees) is no better than supplying in-country markets and most often worse.

Demand

Natural gas has become the preferred fossil fuel where fossil fuels are necessary due to its cleaner burning characteristics and low cost. On a heating value basis (BTU), natural gas in the us is some 3 or 4 times less expensive than the equivalent amount of oil to deliver the same BTU content.

Demand for Electric power from Utility Electric Generators (UEGs) has grown over 32% in the last 5 years. Industrial consumption has grown more than 10% over the same period.

The EIA has monitored consumption increasing from 74.3 billion cubic feet per day (BCFD) in 2017 to 82 BCFD in 2018. They forecast 2020 at 84 BCFD considering both rising regional and export demand.

The EIA has tracked LNG exports and reports a rise from less than 1 BCFD in 2016 to over 4.9 BCFD in 2019. The forecast rises to nearly 10 BCFD by the end of 2020. This is the fastest growing source of demand for natural gas, rising over 21% over the last 5 years.

Exports have exceeded the "Other" category and now are more significant than U.S. commercial users. Exports are expected to exceed residential consumption next year.

The demand picture for short term contract natural gas in the US has very clear peaks and troughs coinciding with the maximum heating and cooling periods of the year. Demand forecasters look at "Degree Days", defined as the number of degrees by which the average daily temperature is higher than 65°F (cooling degree days) or lower than 65°F (heating degree days).

Large consumers like LDCs and UEGs will generally contract for gas in 3 tranches: base load, variable load and peaking load. The base load is largely locked into longer term contracts; variable and peaking are contracted for one or more months at a time.

True peaking load demand can cause price spikes that are outrageous, particularly when coincident with production shortages caused by weather or operational issues. You will not see these prices reflected in the NYMEX but they may be 10 times the going rate or more depending on the situation.

Supply

Natural gas pipelines in the U.S. cover a lot of ground. There are over 2.1 million miles (over 8 times the distance to the moon) of distribution pipelines. These are the lines that run from Local Distribution Companies (LDCs) to consumers.

There are over 300,000 miles (enough to circle the globe more than 12 times) of intra- and interstate pipelines.

There are dozens of natural gas trading hubs in the U.S.  A hub is a physical transfer point where multiple supply and transport pipelines come together. The largest is the Henry Hub in Louisiana. This hub is well connected to four intrastate pipelines which tend to aggregate supplies from field production. It is a central distribution point connecting to nine of the long haul interstate pipelines.

Approximately 1.8 BCF flows through the hub daily. As such, the price of natural gas at the Henry Hub is the most often cited source as a proxy for gas prices. It is the price used for natural gas futures on the NYMEX.

During the first week of August 2019 reported dry gas production was 92.1 BCFD. This was the first time production exceeded 92 BCFD.

Shale gas has been in the news for quite some time. This production comes as a result of new technologies to access previously non-commercial natural gas deposits.

Since 2005, shale gas production has risen from about 3 BCFD to over 66 BCFD in 2019.

Storage

Natural gas storage is utilized to meet load variations, deliver operational integrity for pipeline operators, maintain contractual balance, market speculation, leveling production for production operators, comply with public utility commission (PUC) and other regulations and to ensure commodity liquidity at market centers

Given the chart at left, there is a clear head and shoulders pattern. Any demand above the red line is provided by storage of one kind or another.

The shoulders are important as that is the timeframe where some good investment opportunities present themselves. By recognizing when the prices will rise and fall due to seasonality provides a guide in looking for entry points.

As of 2 Aug 2019, working gas storage stood at about 2,600 BCF out of a total capacity of 4,000 BCF. This is within the average range over the last 5 years as storage capacity generally peaks in October.

Market Action

Bid week

There is a cadence to natural gas pricing that starts with the short term, or spot, market. During the last week of each month, called Bidweek, producers and buyers work frantically to place any short term gas for the next 30 days.

When prices are quoted for natural gas it is always this spot market price. Long term contracts have an entirely different value equation and can vary dramatically from the spot price.

The EIA forecasts Henry Hub prices will increase to an average of $2.75/mcf in 2020 from the current $2.64. This rise is necessary to bring supply into balance with rising domestic and export demand in 2020.

UGAZ and DGAZ

These are leveraged ETFs that aim to track the United States Natural Gas Fund (UNG). UGAZ aims to deliver +3x the performance of UNG while DGAZ aims to deliver -3x the performance. This allows for working both directions of price movement.

Leveraged ETFs are riskier than conventional ETFs. By definition they are designed to provide multiple times the daily performance of the underlying indices: either up or down.

This chart from our Trader Performance Coach (TPC™) software displays this year's buys and sells of DGAZ. You will note that we do not keep the positions very long and if we are on the wrong side, we exit quickly.

Keeping an eye on the UNG is vital to successfully trading these instruments. UNG uses futures contracts and Over the Counter swaps to mimic the natural gas price. As such, it is a proxy rather than a true representation of prices in the physicals market.

We like to track the natural gas futures price for the upcoming month (/NG on Think or Swim).

You also want to watch the rollover dates. This is the date the fund transitions from one set of futures contracts to the next. For UGAZ and DGAZ, this is a 5 business day period commencing on the 5th business day of the month. Each day, 20% of the fund is transitioned from the front-month to the next-month contract. These can be interesting opportunities during shoulder months as there can be larger than normal price spreads between the months.

Here is a chart from TPC showing gains and losses in the Basic Materials sector, the sector we have chosen to use for UGAZ and DGAZ. Not all positions result in winners but we did well overall: certainly better than our oil and chemical positions!

Some guidelines:

• We have found that DGAZ is easier to capture winners than UGAZ.
  
• Use the first 5 business days to your advantage, either up or down, while the instrument transitions from front-month to next-month contracts.
• Watch for weather events like hurricanes in the Gulf of Mexico. They tend to curtail production and drive prices up.
  
• Watch for unusual weather like unseasonably hot in the north during winter or unseasonably cold in the south during summer. Whatever the situation, it will impact natural gas prices.
• Do not hold positions longer than 3 days. Win or lose, exit; no whining, wishing or hoping.
• Never hold a position across a weekend or holiday.