UNG: Not The Way To Profit From Natural Gas (NYSEARCA:UNG)

The United States Natural Gas Fund (NYSEARCA:UNG) is an exchange-traded fund (ETF) that’s designed to track natural gas futures traded on the New York Mercantile Exchange (NYMEX).

I’ve written about UNG a few times here on Seeking Alpha, most recently in a May 23, 2023, piece titled “United States Natural Gas Fund: Much Better Ways to Go Long Natural Gas” when I rated the fund a Sell.

Back in late May of 2023, when I penned my last piece on UNG, front-month US natural gas futures prices were trading just under $2.50/MMBtu compared to around $1.60/MMBtu as of last week’s close:

Indeed, according to data from Bloomberg, front-month gas prices recently hit a level that’s only been tested twice in the past 11 years, in March 2016 and again amid the COVID lockdown commodity crash in the first half of 2020.

As you can see, on both prior occasions, gas prices ultimately enjoyed a strong recovery from sub-$2 lows. In 2016, front-month gas futures surged from a weekly closing low of $1.67/MMBtu on March 4, 2016, to near $3.00 in July and $3.75/MMBtu in December of the same year.

Of course, in 2020 the spring/summer lows for natural gas gave way to significant rallies through the summer of 2022 – front-month gas futures soared from a weekly closing low of $1.50/MMBtu in early 2020 to near $10/MMbtu in August of 2022.

Simply put, with prices near multi-year lows, and considering that historical precedent, it’s only natural to wonder if now marks a great buying opportunity for UNG, a fund that tracks natural gas prices. That bullish view appeared to gain some momentum last Wednesday, when UNG jumped more than 12.5% in a single trading session following natural gas giant Chesapeake Energy’s (CHK) decision to dramatically cut production in response to falling gas prices.

As I’ll explain in this article, I believe the answer remains a resounding no, for two main reasons.

First, even if front-month natural gas prices do rise later this year as I expect, UNG is unlikely to see significant benefit over the next 3 months until the second half of May. In particular, I’ll explain why the Chesapeake news is bullish for gas prices over the long-haul but will have only a limited impact on futures until around the middle of this year.

Second, much like last year, I’d expect high-quality gas producers to handily outperform UNG with less volatility in coming months.

Let’s start with this:

Know What You’re Buying

UNG tracks the front-month natural gas futures contract until approximately two weeks prior to contract expiration when the fund rolls its exposure to the next futures contract.

Here’s the exact roll schedule for 2024:

Look at the row labeled February 2024.

At the beginning of this month, UNG tracked the March 2024 futures; however, between February 13^th and February 16^th, the fund rolled its exposure from the March 2024 contract to the April 2024 contract. Simply put, that means UNG sold the March futures and purchased the April futures, which is the contract this ETF is tracking right now.

Look at the row labeled March 2024, and you’ll see UNG is slated to sell the April 2024 natural gas futures and roll into the May 2024 contract between the 12^th and 15^th of March.

Per Bloomberg, the April 2024 NYMEX natural gas futures price the UNG fund currently tracks is trading around $1.79/MMBtu compared to the March 2024 contract, which trades near $1.70/MMBtu. The last day of trading for March 2024 natural gas futures is Tuesday, February 27^th.

However, when you buy UNG in anticipation of a recovery in prices later this year, you’re not buying natural gas at $1.79/MMBtu.

Holding UNG over time can better be considered a series of trades rather than a single investment:

This chart shows the price of natural gas for delivery in each calendar month from March 2024 to December 2025.

As I said, the April 2024 futures are trading near $1.79; however, that price rises to $2.33/MMBtu for delivery in July 2024, $3.64 in January of next year and over $4/MMBtu by the end of 2025.

So, if you buy UNG today and hold for the next 3 months, you’re not really buying gas at under $1.79/MMbtu, you’re buying exposure to gas at $1.79 from now until UNG rolls to the May contract between March 12-15th, and then you’ll have exposure to the May contract which currently sells for about $1.92/MMBtu. On April 12-17th, your exposure would then shift from the May contract to June, which currently sells for near $2.15/MMBtu.

So, over the next (roughly) two weeks until UNG rolls to May futures, the only fundamental developments that can impact the price of the ETF are those that impact the supply and demand balance for gas between now and April.

The prospects for a hot summer this year that could drive elevated demand for natural gas to power air conditioning is irrelevant for April futures because hot weather in July doesn’t drive demand for gas in April.

Take a look:

I created this chart using data from the Energy Information Administration’s Natural Gas Supply Monthly report over the past few years.

This chart shows seasonal demand for gas in the US based on the 5-year monthly average. I’ve broken demand into two categories – demand for gas in electricity generation (blue segment of each column) and all other sources of demand (orange segment). Air conditioners run on electricity, so summer cooling demand shows up in the form of a surge in demand for natural gas from the electricity generation sector.

Two features of this chart really jump out.

First, summer cooling demand is far less important to the US natural gas market than winter heating demand. Based on this 5-year monthly seasonal average data, January is the peak winter month for natural gas demand, while July slightly edges out August in terms of peak summer demand. However, on average, total US gas consumption in January is 35.5% higher than demand in the month of July.

Second, historically demand for natural gas from electricity generators bottoms in the month of April; however, from a seasonal perspective, electricity and cooling demand don’t typically become a major fundamental driver of gas fundamentals until June at the earliest. July and August are, by far, the most important months of the year for gas demand from power producers.

Look at my table above, and you’ll see UNG doesn’t roll into the June 2024 natural gas contract until April 12-17th, 2024, and it won’t roll into the July contract until May 15-20^th, 2024. Simply put, if you’re looking to trade summer heat and the consequent surge in natural gas demand, then UNG won’t be a compelling buy candidate until mid-April at the earliest and, more likely, the second half of May when UNG jumps into the peak summer contract of July 2024 natural gas futures.

And that brings me to this:

The Chesapeake Effect

As I noted earlier, US natural gas producer, Chesapeake Energy, sparked a powerful one-day rally in natural gas futures and the UNG fund.

In 2023, Chesapeake produced 3.47 bcf of natural gas per day, from two main fields, the Marcellus of Appalachia and the Louisiana Haynesville. That ranks the company behind EQT Corp. (EQT), a stock I wrote about in a February 16^th Seeking Alpha article “EQT: The Low-Cost Gas Producer is a Buy,” in the league table of US shale gas producers.

However, following CHK’s planned merger with Southwestern Energy (SWN), a company I wrote about in a bullish piece back in December, the combined CHK/SWN would be the largest shale gas producer in the US.

CHK’s sheer size and scale means its decisions regarding capital spending (CAPEX) and production have a significant impact not only on the company itself, but on supply for the US natural gas market as a whole.

After the market close on February 20^th, citing weak natural gas market conditions, CHK announced a plan to cut its planned CAPEX for 2024 by 20% from its prior guidance to a range of $1.25 to $1.35 billion. To achieve this CAPEX cut, CHK plans to defer turn-in-lines (TILs), build drilled, uncompleted wells (DUCs) and drop its rig count from 9 active rigs at the beginning of this year to 8 rigs by March and 7 rigs by mid-year.

Let me explain.

A turn-in-line (TIL) is an energy industry term that refers to the process of moving a well from drilled and completed (fractured and ready to produce) to actual production and sales of natural gas. So, TILs are wells that are ready to produce natural gas; by deferring TILs, CHK is simply not producing gas immediately from wells that it has already drilled and completed.

Note that this is different from DUCs. DUCs are wells that have already been drilled but have not yet been fractured, a necessary step to producing commercial quantities of natural gas from shale fields. So, while you don’t need a drilling rig to put a DUC into production, you do need a fracturing spread, a crew and high-pressure pumping equipment needed to fracture a shale well.

Put in a different way, a TIL is closer in time and readiness to commercial production than a DUC.

Here’s how CHK’s Chief Operating Officer, Josh Viets, explained the process during the Q&A portion of CHK’s Q4 2023 conference call hosted on February 21^st:

I think just the other thing I would comment on is we’re going to be very prudent around how we activate production. And the optionality that we like about the deferred TILs is that it gives us an immediate response when we see that structural change in the gas markets. And so we would anticipate that we would start to activate the TILs and then we would likely soon after begin starting to activate some of the DUCs. But one thing to keep in mind is that any production associated with those deferred completions is effectively going to lag by a quarter. And so we do see that as effectively starting to backfill the TILs that we’re starting to activate in the prior quarter. So we really like the cadence that is set up by this. And again, we think it offers quite a bit of flexibility for us going forward.

CHK explains that when it sees an improvement in the supply-demand balance in US natural gas markets, the company would activate TILs first – since these wells are ready to be put into production, they can give CHK almost immediate new supply of gas to take advantage of higher prices.

Later on in the same call, Josh Viets noted that CHK could reactivate its planned deferred TILs for 2024 in a matter of weeks, providing a rapid 1 billion cubic feet per day (1 bcf/day) in natural gas production uplift from deferred TILs alone.

The DUCs take more time to activate because the company still needs to fracture these wells – in the above quote, CHK estimates that once it starts completing DUCs, it would take a full quarter for that to show up in the company’s actual production figures.

In the company’s earnings results presentation, CHK estimates that it would cost CHK less than $50 million to put all of the deferred TILs it plans to build in 2024 into production and about $175 million to complete planned 2024 DUCs.

Simply put, by deferring TILs, CHK is essentially storing 1 bcf/day of natural gas production that could be brought online within weeks at a minimal cost ($50 million is less than 4% of CHK’s planned 2024 CAPEX). Following those reactivated TILs, CHK could bring online DUCs to lift production within 1 to 2 quarters at a higher cost.

In effect, when US natural gas pricing and fundamentals improve, CHK is set up to respond in 3 steps:

1. Put deferred TILs into production for an (almost) immediate production uplift at a low cost.
2. Complete DUCs and bring production online in about 1 quarter at a higher cost.
3. Increase activity by contracting for new drilling rigs and fracturing spreads to drill and complete new wells, a process that takes more than months to show up in the form of new gas output and requires a significant increase in CAPEX.

CHK’s announcement is important and will have an important impact on US natural gas supply; however, it will take time to meaningfully impact the supply demand balance.

Take a look:

This chart shows CHK’s historic production from Q1 2023 through Q4 2023 broken down by its two operating regions, the Marcellus and Haynesville Shale fields. The Q1 2024 column represents the midpoint of CHK’s Q1 2024 production guidance for both operating regions, outlined in their presentation slides accompanying the company’s Q4 2023 results.

Finally, during the Q&A portion of the company’s conference call, COO Josh Viets indicated that overall CHK production is expected to decline just under 30% from Q4 2023 to Q4 2024 and that the decline would be “pretty steady.”

So, a 30% production decline for CHK from the Q4 2023 level would peg the company’s total output at about 2.26 bcf/day in Q4 2024. To create estimates for Q2 2024 and Q3 2024, I simply took the Q1 2024 production level in the company’s guidance and assumed a steady quarter-over-quarter percentage decline in output to get us to a production level of 2.26 bcf/day in Q4.

So, the first thing to note here is that while CHK’s CAPEX and production guidance cutbacks are significant on a year-over-year basis, there’s very little impact on production in Q1 2024. Based on the mid-point of guidance, CHK’s production in Q1 2024 will drop by just 0.085 bcf/day between Q4 2023 and Q1 2024, a decline of 7.65 bcf for the entire quarter.

Let’s put that into context – the EIA estimates that US dry gas production in the most recent month for which it has finalized data (November 2023) was 3,179 billion cubic feet (3.179 trillion cubic feet) in total (not per day). So, a 7.65 bcf total cutback over 3 months is insignificant to the US gas market supply/demand balance.

By Q2 2024 my estimates are that CHK’s total production decline from Q4 2023 levels reaches about 0.42 bcf/day, which works out to around 38 bcf in total production decline for the quarter as a whole. So, that’s more meaningful, but it’s still less than 0.5% of total US gas production over the past 3 months for which the EIA has data.

My point is that even though CHK’s strategy of deferring TILs has a more immediate impact on supply than building DUCs, it still will take a few quarters for the cumulative impact to add up to a significant share of US gas production. So, much of the bullish supply impact from the CHK news will not be felt until the second half of 2024.

Trading in natural gas futures already reflects this reality:

This chart shows the US natural gas futures curve through the end of 2025 on two dates, February 20, 2024, just before CHK’s announcement and Monday, February 26th, 2024 a few days later. The grey columns (see right-hand scale) show the change (increase) in gas prices between these two dates.

What’s interesting is that initially, front-month gas prices jumped on the CHK news – according to Bloomberg, the March and April 2024 futures soared almost $0.20/MMBtu and $0.22/MMBtu respectively between settlement on February 20^th and 21^st.

However, as you can see in my chart above, these front-month contracts have given back almost all of those knee-jerk gains – March and April 2024 futures are now up only about $0.08/MMBtu and $0.11/MMBtu respectively since settlement on February 20^th.

The much bigger impact has been on pricing for next summer — July 2024 futures are some $0.237/MMBtu (about 11.1%) higher than they were on February 20^th while August prices are up $0.252/MMBtu. Not surprisingly, that timing is consistent with the production estimates I just outlined for CHK – the company’s deferred TILs and DUCs will start to have a meaningful cumulative impact on production by around Q3 2024 (July through September 2024).

Again, however, tighter supply from lower US gas production just doesn’t help UNG much until the second half of May, when it will roll into the July 2024 natural gas futures.

Bullish on Gas, Buy the E&Ps

Rather than buying an ETF like UNG or the ProShares Ultra Bloomberg Natural Gas ETF (BOIL), which I wrote about earlier this month on Seeking Alpha, consider a high-quality natural gas exploration and production (E&P) company as an alternative.

Last year, for example, select E&Ps offered superior upside leverage to a gradual rally in gas prices than UNG:

This chart shows NYMEX natural gas futures prices since the end of 2022 based on two different measures, the front-month futures as described earlier, and the 12-month calendar strip price.

The 12-month calendar strip is simply the average price of natural gas futures for delivery in each of the next 12 calendar months – on Monday, February 26^th, for example, the 12-month strip would include the average price of every futures contract from March 2024 through February 2025.

One major advantage of the strip price is that it helps eliminate the impact of the seasonal demand patterns I outlined earlier. For example, gas futures for delivery in a period of peak demand like January usually fetch a higher price than contracts for delivery in a period of weak demand like April; this seasonal reality tells you little about underlying supply and demand conditions for gas over the intermediate term.

However, what’s important here is that regardless of how you measure prices, natural gas hit a low between late March and early April 2023 and rallied through to the end of October of last year.

With that in mind, look at this chart:

This chart shows the total return – capital gains and dividends paid – for 5 different securities leveraged to natural gas between the end of March 2023 and the end of October. That’s the period when gas prices generally rallied in 2023 as I outlined just above.

The two natural gas ETFs, UNG (blue line) and BOIL (orange line), returned +8.1% and -4.6% respectively over this period.

The front-month price of natural gas was at $2.22 on March 31^st and the 12-month strip was at $3.06, rising to $3.58/MMBtu and $3.55/MMBtu respectively by the end of October. So, it’s fair to say natural gas prices enjoyed a significant rally over this time, while the ETFs that track natural gas futures prices directly saw only modest gains or even losses.

I’ve also included 3 E&P (producer) stocks on my chart. As I mentioned earlier, EQT and SWN are names I’ve written bullish articles about here on Seeking Alpha while Comstock Resources (CRK) is a producer I wrote a sell recommendation on back in late January “Comstock Resources: Serious Cash Flow, Debt and Dividend Headwinds Loom.”

As you can see, all three of these E&Ps dramatically outperformed UNG and BOIL amid a steady rally in gas prices from March through October last year.

My rationale for preferring EQT and SWN to CRK are that the former names have lower total cash flow breakeven costs – they can generate free cash flow at lower gas prices – and both names also have superior hedge coverage over the next few quarters to protect their cash flows from near-term depressed gas prices. In short, I see EQT/SWN as higher-quality names with less near-term commodity price exposure.

The even better news is that amid last year’s gas rally, you did not have to move out the risk curve and buy higher cost and less hedged producers to benefit from the rally in natural gas prices — both EQT and SWN handily outperformed CRK over this time frame.

And take a closer look at my chart, and you’ll notice that the SWN and EQT lines represent smoother uptrends than the lines for UNG/BOIL and CRK. Indeed, the annualized standard deviation of daily price changes – a measure of volatility – for UNG and CRK over this time period was about 51.7% and 47.0%, respectively, compared to just 34% for EQT and 35.8% for SWN.

In other words, the high-quality producers provided more leverage to an intermediate-term rally in gas prices than the ETFs, or the higher cost producer, with less volatility.

One more chart to consider:

This chart shows total returns for the same 5 natural gas levered securities I profiled above since December 12, 2023.

Flip back to my chart of gas prices, and you’ll see that since December 12^th, the front-month price of gas is down sharply; however, the 12-mopnth calendar strip is roughly flat. Moreover, while front-month gas prices have generally been weak since December 12^th, prices did experience a material rally between December 12^th and January 12^th amid a period of very cold winter weather across the US.

As you can see, both UNG and BOIL saw strong gains from mid-December through mid-January amid the short-term rally in gas at that time. Over the entire period, however, the two high-quality gas E&Ps – EQT and SWN – have generated superior returns.

This highlights a key lesson for would-be buyers of the gas ETFs – if you’re expecting a short-term rally in gas catalyzed by a fundamental tightening in supply-demand conditions such as extreme cold, then UNG and BOIL can work as trading vehicles. However, if you’re seeking a way to profit from a longer-term tightening in supply-demand fundamentals and recovery in gas prices, then the high-quality, low production cost E&Ps are generally a lower-risk, higher-reward investment option.

Conclusion

With natural gas prices reaching multi-year technical support levels in recent weeks, some investors are tempted to buy UNG as a way to profit from a recovery in natural gas prices into the summer months.

However, the two most often-cited upside catalysts for gas right now — the prospects of hot summer weather and tightening supply as a result of CHK’s production cuts — are unlikely to have much of an impact on supply and demand conditions until July 2024. And UNG will not roll into the July 2024 NYMEX natural gas contract until May 15-20th, 2024.

UNG does not represent a way to buy gas at current depressed prices –it’s better considered a series of trades over time as the fund rolls from one futures contract to the next according to a pre-set roll schedule.

Given the lack of near-term, upside catalysts for natural gas prices, UNG rates a sell.

More broadly, natural gas ETFs like UNG historically represent a valid way to trade a short-term rally in natural gas due to specific catalysts. A classic example would include the Artic blast, and associated elevated heating demand for gas, early this year.

For intermediate-term rallies, such as we saw between March through October last year, high-quality low production cost producers like EQT and SWN generally offer superior upside with less volatility than UNG.

Investors looking to benefit from higher demand this summer or a tightening in gas supply from CHK”s recent production cuts should consider a producer rather than UNG.