Another Sign Natural Gas Is Getting Hot

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For years, natural gas has been the odd duck in the booming energy industry. Exploration and production companies have found huge reserves of natural gas in unconventional plays, but a relative lack of demand compared to crude oil not only prevented prices from going up, but actually sent them to decade lows.

But in the past couple of months, natural gas has bounced back. In fact, it's come so far, so fast that a long-held relationship in the futures market has reversed itself, making what was once a much-scorned exchange-traded fund linked to natural gas futures look attractive again, at least for the moment.

The last contango?
The ETF in question is the United States Natural Gas ETF (NYSE: UNG  ) . With the very simple investment objective of trying to track the price of natural gas, the ETF has suffered huge losses in recent years.

With natural gas prices having slipped from double-digits in early 2008 to less than $2 earlier this year, those losses may not sound surprising. But the ETF actually underperformed the change in the spot price of natural gas by a considerable margin, due to a peculiarity in the prices of natural gas futures.

For most of the past several years, natural gas futures have been in a state of contango, which means that the price of near-term futures contracts is less than the price on longer-term futures. On one hand, this makes the futures that the U.S. Natural Gas ETF buys cheaper, because it focuses on the front month contracts. But because the ETF eventually has to roll its contracts forward in order to avoid taking delivery, it suffers from the generally higher price on the new contracts compared to the front month contracts it's closing out.

Recently, though, as Tom Lydon of ETF Trends noted earlier this week, natural gas futures have recently moved out of contango and into the opposite state, known as backwardation, for the first time in nearly a year. With backwardation, front-month contracts have higher prices than subsequent months, and that benefits the U.S. Natural Gas ETF. In fact, the natural gas market has been in a state of backwardation for most of July, and those who've rolled front-month contracts have earned an annualized return of 4.6%.

What's behind the move?
Earlier this month, Bloomberg News speculated that power plants were behind the heavy spot demand for natural gas. With Southern Company (NYSE: SO  ) and Duke Energy (NYSE: DUK  ) moving toward more natural-gas power generation, electricity demand based on summer weather has finally gotten gas prices out of the doldrums as utilities have had to buy more gas.

That switch has been bad news for coal producers Peabody Energy (NYSE: BTU  ) and Alpha Natural Resources (NYSE: ANR  ) . Yet even after the big surge, it still isn't enough to really help most natural-gas producers, most of which have break-even production cost points well above current prices.

Will the good times last?
Unfortunately for gas ETF shareholders, the futures markets aren't betting on backwardation lasting very long. Currently, if you go past September, the gas-price futures curve again asserts its upward slope, with October contracts fetching higher prices than September. Part of that comes from increased demand for gas for heating purposes, as prices are typically higher in the colder months.

But if contango comes back into the market, the U.S. Natural Gas ETF will once again start to erode investors' assets. Although the current backwardation is a nice break from past trends, investors shouldn't count on it lasting very long -- even if longer-term prospects for natural gas prices remain higher.

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Fool contributor Dan Caplinger prefers cold weather and out-of-favor investments. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. Motley Fool newsletter services have recommended buying shares of Southern. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy has lots of energy.

Read/Post Comments (3) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 27, 2012, at 6:03 PM, rockytina wrote:

    Anyone who talks about an oversupply of natural gas or an abundance of natural gas must be living in a dreamworld.

    Natural gas production today is the same as this time in 2011 and falling fast. Natural gas production today is 3-4% below the levels of December 2011.

    Check EIA data.

    Natural gas is held hostage to supply and demand. Until natural gas prices reach the cost of producing natural gas, natural gas production will decrease as it is doing now.

    The cost of producing natural gas is probably somewhere between $4-8 BTU and when we will reach those levels guess what - coal will be the preferred energy source at those levels.

    Please, stop this nonsense about about much natural gas we are producing and how economical natural gas is. Natural gas is expensive and will not be able to compete with coal - sorry greenies.

    But for the greenies, methane, which natural gas production and transportation spouts in unlimited amounta has 30 times the effect as CO2 on global warming - if you naive enough to believe inn global warming

  • Report this Comment On July 28, 2012, at 1:01 PM, enthuskeptic wrote:

    Nat. gas - ng - is the cheapest fuel for cars and light trucks and vans, used in most of the world. NG is also used for producing electricity etc. If exporting it from North America - NA - takes off in 2014 we should definitely be ready to invest in ng producers, pipelines and LNG shippers, and companies selling ng in foreign markets.

    Large ng deposits are found all over the world, but maybe ng from NA can help to tide the world over until the other sources are developed?

  • Report this Comment On July 29, 2012, at 8:37 AM, sevenheart wrote:

    Rockytina is pretty much right except for the cost/ quantity. It costs $4-8 per 1000 cubic feet (mcf) which is generally equivalent to 1 million btus. Another industry abbreviation you'll see is mmcf which is a million cubic feet.

    The reason production is down is that gas wells can be "shut in", in other words if the cost of production exceeds market value, the well is simply closed until market conditions improve.

    Enthuskeptic has some things right, but keep in mind, an oil rig can drill for gas, oil or both, most are not specialized for one or the other. Rig utilization has shifted to drilling more specifically for oil or natural gas that produces natural gas liquids. Keep in mind natural gas(and oil) is used for much more than transportation or electrical generation. Pipe is utilized for drilling and transportation, a lot of transportation infrastructure has already been built during this last boom, but collection and processing facilities will follow the next boom.

    Mr. Caplinger has several facts wrong, but he writes about dozens of topics, can't be an expert at all of them. If you are considering energy investments, I would not rely on anything from the Motley Fool, to educate yourself and stay current with the industry check out rigzone, you can get industry news in daily and/or weekly emails, much of it in plain language. Another good source, but due too the lag of publication is slow is World Oil. They offer online info as well as email highlights. One of the best things to learn to read and monitor is the Baker Hughes rig report, on their website tied to investor relations. There you can see trends in rig use, application and areas where activity is going up or down, state by state, nation by nation, onshore and offshore as well as historical data. Use these and you'll be way ahead of the Fool.

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