UNG Is Due for a Comeback

The United States Natural Gas Fund, or UNG, is due for a comeback. Here are six reasons why.
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By Michael Johnston of ETF Database

By some measures, the

United States Natural Gas Fund

(UNG) - Get Report

has been one of the great ETF success stories of recent years. Since its inception in April 2007, it has become one of the largest and most popular exchange-traded commodity products.

The fund saw cash inflows of more than $5.5 billion in 2009 and currently has more than 400 million shares outstanding.

But the fund's success in attracting assets hasn't been matched by a successful investment return. Unfortunately for investors responsible for the fund's growth, UNG has been one of the

worst-performing ETFs

in recent years, losing more than 50% in 2009 and already sliding another 30% this year (see

UNG's historical performance

).

In addition to the adverse impacts of

contangoed futures markets

, natural gas ETFs have been hit by a perfect storm of negative fundamental factors. New technological developments and massive discoveries of resources have caused supplies to balloon, while the recent economic downturn sapped a significant portion of industrial demand from the market. Although equity markets have staged a nice recovery, the rally has been driven in large part by expectations; demand for many raw materials and energy sources is yet to fully materialize. With no demand to match surging supplies, prices have slid steadily lower.

52-Week Chart of United States Natural Gas

Despite the prolonged downward slide, some investors are optimistic that natural gas prices will head higher in coming months. Below, we profile six trends that could reverse UNG's free fall.

1. The Price of Crude Oil/Natural Gas Is out of Whack

UNG's assets have surged in size in recent years in part because investors noticed that the ratio of

crude oil

to natural gas prices had deviated significantly from its historical average and anticipated that this divergence was reflective of short-term market fluctuations. But so far, the gap has only grown, as the relationship between the two energy sources has weakened considerably.

At its current level of than $80 per barrel, crude oil is about 20 times the price of one million British thermal units, which recently slipped below $4/MMBtu. That ratio has fluctuated historically but has generally stayed pretty close to 10. In order to get back to this norm, natural gas prices would need to double, which would still put them well below levels touched only a few years ago.

Crude oil and natural gas aren't perfect substitutes. But with gas attractively priced relative to oil, an intermediate-term shift away from crude and towards gas isn't inconceivable.

2. Big Oil Is Making a Big Bet on Natural Gas

The energy sector has seen a

string of acquisitions

in recent months that all hint at expectations of an increased interest in natural gas going forward.

Late last year,

Exxon Mobil

(XOM) - Get Report

agreed to acquire

XTO Energy

(XTO)

, one of the fastest-growing energy producers in the U.S. XTO's resource base is the equivalent of 45 trillion cubic feet of natural gas, including shale gas, tight gas, coal bed methane and shale oil.

In February,

Schlumberger

(SLB) - Get Report

agreed to acquire

Smith International

(SII)

, a supplier of products and services to gas production and exploration companies.

The Smith acquisition came after Schlumberger's rival

Baker Hughes

(BHI)

bought

BJ Services

(BJS)

last year, snapping up one of the leading providers of pressure-pumping services critical to natural gas extraction. And most recently,

Apache

(APA) - Get Report

and

Mariner

(ME)

agreed to merge

, combining two firms with significant oil and natural gas assets.

Big Oil

is clearly betting that natural gas will be expanding its market share in the global energy market in coming years, as several major oil companies are taking steps to expand natural gas operations. It seems unlikely that these rich acquisitions would be occurring if prices were expected to continue to slide. Moreover, Big Oil's buying spree gives natural gas another proponent with an incentive to stabilize and increase prices.

3. Alternative Energy Has Hit a Wall

With governments throughout the world facing unprecedented fiscal crises, subsidies to still-nascent clean energy industries have been drastically cut back, or in some cases eliminated altogether. European nations are bracing to bail out one of their neighbors, and have cut off support to wind and solar energy industries (see

Solar ETFs: Headed For A Burnout

). Some alternative energy ETFs have declined nearly 20% already in 2010, as government assistance has eroded profit margins.

Wind and solar energy aren't dead, but their growth curve certainly seems to have flattened out a bit in the wake of the recent economic downturn. The road to economic feasibility has been extended as funding has cut off, leaving fewer clean energy alternatives ready to alleviate reliance on foreign oil in the short term. This could create an opportunity for natural gas to step in.

4. GCEF Could Be Next OPEC

Ministers from the world's 11 largest natural gas producers, which in aggregate account for 70% of global reserves and participate in the Gas Exporting Countries Forum,

have agreed to work to index

natural gas to oil, saying that such steps are necessary to encourage investments in exploration and production. Algerian Energy Minister Chakib Khelil expressed hope that the meeting of gas-producing nations would "mark a new era for our organization." He also said that declines in exports to the U.S. have been a major factor in pushing global prices lower.

Khelil insisted that a "new model of cooperation must be devised," in order to encourage long-term investment. Qatar's Energy Minister Sheik Abdullah bin Hamad al-Attiyah echoed similar sentiments, telling reporters that the bloc of countries "must find a mechanism for a just price for gas and to stabilize the market." Natural gas was once strictly a local commodity, but technological developments have made storage and global transport feasible, potentially altering the universe of suppliers available to end users.

Several member countries reportedly pushed to form a cartel-like organization that could influence prices by implementing output quotas. Analysts note that a cartel-like structure is unlikely, since agreements to production cuts would be nearly impossible to agree upon. But the recent meeting indicates that the Gas Exporting Countries Forum is serious about stabilizing gas prices.

5. EPA's Inquiry Into Fracking

Last month, the Environmental Protection Agency announced that it was

beginning an investigation

into the drilling technique known as hydraulic fracturing, or "fracking," that has contributed to the surge in natural gas supplies in recent years. "Our research will be designed to answer questions about the potential impact of hydraulic fracturing on human health and the environment," said Paul Anastas, assistant administrator for the EPA's Office of Research and Development.

Fracking involves injecting a mixture of water, sand, and chemicals into rock formations to stimulate natural gas production. Some environmental groups claim the practice is unsafe and think it should be regulated by the federal government. Separately, the House Energy and Commerce Committee is conducting its own investigation into the effects of fracking.

The outcome of the investigation is neither certain nor imminent -- the EPA said its study could take two years to complete -- but it is clear that the impact could be significant. Shale rock formations account for as much as 20% of U.S. natural gas supplies, meaning that any ruling pleasing to environmentalists could restrict supplies.

6. Analyst Estimates Greater Than Futures Curve

Credit Suisse

expects natural gas

to hit $4.66 this year, which represents a significant reduction from its previous forecast of $5.25/MMBtu. The futures curve for natural gas contracts rises throughout 2010, but doesn't go above that level until December, and averages just $4.38 between May and December. Wall Street isn't always right, but if the projections from some big banks are even close to accurate, UNG could be due for a turnaround.

Headwinds Remain

As many investors know by now, the spot price of natural gas is only one of the factors that impacts the share price of UNG. And sometimes it's not even the most significant one. At present, contango in natural gas futures markets, the same factor that was responsible for a significant portion of last year's losses, is creating some strong headwinds for UNG. The curve slopes steadily upward through January 2011, with futures contracts for the first month of next year recently trading at more than a 35% premium to May contracts.

So keep in mind that upward movements in spot natural gas prices might not be enough to lift UNG.

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At the time of publication, Johnston had no positions in equities mentioned

.

Michael Johnston is the senior analyst and founder of ETF Database, a Web-based investment resource providing actionable ETF investment ideas and an

ETF Screener

for investors analyzing potential ETF investments. Johnston oversees ETF Database's free

ETF Newsletter

, one of the most popular sources for news and commentary focusing exclusively on the exchange-traded fund industry. Johnston also maintains and develops content for

ETFdb Pro

, a line of analyst reports and model portfolios designed to help investors utilize ETFs to meet their investment goals.

Johnston has completed the Chartered Financial Analyst (CFA) program, and obtained his bachelor's degree in finance from the University of Notre Dame. Prior to founding ETF Database, Michael worked in a private client service group performing valuations of companies operating in a wide range of industries.