Another Sign Natural Gas Is Getting Hot

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 (NYS: 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 (NYS: SO) and Duke Energy (NYS: 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 producersPeabody Energy (NYS: BTU) and Alpha Natural Resources (NYS: 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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