Five Drivers Of UNG's Spring Rally

After a government report showing that natural gas supplies increased less than expected last week, the United States Natural Gas Fund (NYSE: UNG  ) climbed higher by almost 3% on Thursday, extending a rally that has seen the popular commodity fund add almost 20% this month. The rebound comes after natural gas prices had plunged steadily lower over the past two years, hammered by weak industrial demand in the U.S. and massive new discoveries of gas reserves.

Prior to the June rally, UNG had lost about 85% of its value since its inception in April 2007; in addition to weak natural gas fundamentals, crippling contango in futures markets had created a steady return drag on the futures-based fund (see Three ETFs Crippled By Contango). The turnaround in UNG's performance has been sudden; a run-up of 25% in less than four weeks has made the fund one of the top ETF performers in June. The rally hasn't been attributable exclusively to one factor, but rather the combination of several positive developments impacting both the supply and demand sides of the natural gas equation (for more ETF insights, sign up for our free ETF newsletter):

5. Warm weather
During the winter months, natural gas prices may get a boost from colder-than-expected weather, which drives up demand for residential heating. In the late-spring and summer months, it is warm weather that can send natural gas prices higher. That's because higher-than-usual temperatures drive up air-conditioning demand, which in turn leads to increased usage of natural gas. In recent weeks, temperatures throughout the country have been higher than normal, giving gas prices a boost. It's obviously difficult to predict whether this trend will continue throughout the summer; a cold snap could certainly reduce demand for natural gas, at least temporarily.

4. Regulatory environment
In the wake of the devastating spill in the Gulf of Mexico, the oil industry has seen regulatory scrutiny intensify dramatically in recent weeks. A moratorium on deepwater drilling could significantly impact the ability of the energy industry to access massive reserves of natural gas discovered in recent years, a development that would no doubt put downward pressure on prices. Gas prices have been pummeled in recent years by swelling supplies; the threat of a partial ban on drilling has helped to reverse some of those losses.

In addition, the EPA is currently conducting an investigation into the potential human health and water quality threats posed by "fracking," an increasingly popular technique used to unlock natural gas reserves, which has been criticized by environmentalists. That report isn't scheduled to be released until 2012, but the possibility of increasingly stringent regulations when it is released is very real (see Five ETFs To Watch After Obama's Oval Office Address).

3. Hurricane jitters
With the official start of hurricane season now in the rear view mirror, several organizations have rolled out their forecasts for coming months. The National Oceanic and Atmospheric Association is predicting one of the strongest seasons on record. NOAA is calling for 23 named storms during the Atlantic hurricane season, with three to seven classified as major hurricanes.

Because a significant portion of the natural gas used in the U.S. originates from the Gulf of Mexico, an active hurricane season can lead to significant supply disruptions; following hurricanes Katrina and Rita in 2006, natural gas prices hit record highs, climbing above $16.

2. U.S. recovery continues
The major story of the last several months has been the fiscal woes of Europe, as governments across the continent have taken drastic measures to reel in spending and prevent the spread of a sovereign debt crisis. Although these fears have weighed on equity markets around the world, the last month has actually seen a number of data releases painting a relatively rosy outlook for the U.S. economy. The long-dormant manufacturing sector is showing signs of life, as factory job creation has picked up considerably.

Unlike crude oil, natural gas is largely a local commodity; its physical properties make long-distance transportation a prohibitively expensive logistical nightmare. So natural gas prices are insulated from Europe, much more so than most equity markets. In this sense, UNG is a pure play on the domestic U.S. economy; increases in industrial demand and a bullish outlook on the manufacturing sector have boosted gas prices (see UNG's Rally: Proof Of A U.S. Recovery).

1. Contango eases
The final reason behind UNG's impressive run has nothing to do with natural gas fundamentals, and is related to the nuances of futures-based ETF investing. UNG doesn't actually invest in physical natural gas, but rather achieves its exposure to the commodity through exchange-traded futures contracts. Since UNG invests primarily in near-month futures contracts, it has to "roll" holdings on a monthly basis to avoid taking physical possession. When futures markets are contangoed -- when long-dated contracts are more expensive than near-dated futures -- the yield incurred in the roll process can eat into returns.

Natural gas markets are futures are contangoed, but the slope of the futures curve is more moderate than it has been in recent months; August futures were recently trading at a premium of less than 1% to July contracts. This contango is still eating into UNG's returns, causing it to lag a hypothetical return on spot natural gas. But the impact has been more moderate recently, a welcome development for investors in the fund (see How Contango Impacts ETFs).

Disclosure: No positions at time of writing.

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The Fool has opened a diagonal call spread position and written puts on United States Natural Gas. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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