The epic flows of the last few months into the United States Natural Gas Fund ETF may be very counter-intuitive as far as predicting an upturn in the price of natural gas.
That, at least, is the message from Goldman Sachs on Wednesday, which sees natural gas prices remaining weak throughout the coming weeks.
Regarding the oil/gas ratio, which has consistently set historic highs over the last few weeks, Goldman say (our emphasis):
Surge in US unconventional gas production has led to a disconnect between natural gas prices and the oil complex
The surge observed in US natural gas production in the past two years has eliminated the need for gas-to-oil substitution in the US to guarantee sufficient natural gas supplies during the winter. As a result, the oil/gas ratio is near historical highs. We believe this ratio can increase further this summer as natural gas prices remain under pressure to curtail supply (through persistent drilling cuts) and incentivize demand (through coal-togas fuel substitution). In contrast, we expect oil prices to continue to rise through year-end (and thereafter) as fundamentals improve. Given that this marked difference in fundamentals between oil and gas is not fully embedded in the forward market through the end of 2009, we are opening a trading recommendation to go long the oil/gas ratio.
The oil/gas disconnect can persist in the near-to-medium term, but is not sustainable in the long run
In the near term, substitution capacity between oil and gas is limited. Although some switching away from oil and into natural gas can be done in Asia, it is unlikely to move the LNG market enough to support US natural gas prices, particularly as US natural gas prices represent a floor for spot LNG prices this year, and not the other way around. In the long run, however, we believe that such a wide discount of natural gas relative to oil is not sustainable. Either via an increased use of natural gas vehicles (NGVs), electric cars or the mass scaling up of gas-to-liquids (GTL) technology, we believe that this wide arbitrage opportunity will eventually close as the oil market will find ways to demand more of the cheaper fuel.
So while the oil/gas ratio is likely to normalise eventually (but we’re talking in years, rather than weeks), the short-term picture sees the ratio widening as natural gas prices either weaken further or stay stagnant as oil prices move higher.
In case you think that might just be Goldman talking its book, CFTC data confirms that most non-commercials active in the Henry Hub natural gas futures market (which can be taken to mean funds) are currently net short. That is to say, professional investors appear to be betting the price of natural gas will fall in the short term.
This is distinctly the opposite of the position of the United States Natural Gas ETF’s, a vehicle that in contrast is very much a long-only player and particularly partial to the whims of retail investor sentiment.
Let’s hammer the point in as succinctly as possible: The UNG fund is long in the futures market, while most professional investors are short.
Reuters also reports in the same story:
Traders noted that despite their net short futures and options exposure, funds were still carrying a sizable net long position in Henry Hub natural gas swaps, increasing the total by 5,888 contracts to 506,233 in this report. The Henry Hub natural gas swap contract is one-fourth the size of the Henry Hub futures contract, or 2,500 mmBtus, so funds are holding the futures equivalent of about 126,558 net longs.
As it is highly unusual for funds to be invested in the phyiscal swap market, it being the domain of commercial and physical players mostly, the reference above can pretty much be taken to mean the UNG fund. The fund’s daily investment listings confirm that it has been growing its positions in the swap market almost on a day-by-day basis, most likely forced into the market to avoid breaching position alerts in the more heavily-regulated futures market.
So if you understand that, you understand that most of the UNG’s counterparties in the swap market must be net short commercial and physical players. So, in other words, the UNG is helping, most likely naturally long, commercial and physical positions hedge their positions in what is predicted to be a descending or stagnant market.
We know which side of the bet we’d prefer to be on.
Cramer doesn’t get the UNG – FT Alphaville
More weirdness in the UNG – FT Alphaville
The problem with commodity ETFs – FT Alphaville
Strange things still afoot in natural gas – FT Alphaville