Occasionally, a Commodity offers prices to investors at a deep discount. Many times, there is a reason for a market to be cheaply priced, and we would do well to keep shorting that market. We have all seen a stock that was trading for $80 per share and weeks later, see it trading for $15. Our first thought is this is a bargain because the price has dropped so much. Many brokers call their clients that were put in the stock at $80 and tell them, “If we liked it at $80, then we have to love it at $15.” Unfortunately, for most investors, the stock usually continues on down and eventually goes to $0. That is the nature of stocks; when they are cheap, there is a good reason and we should avoid them at all cost.
Commodities, on the other hand, are a different creature. Unlike a stock, which nobody has to have, Commodities are a true supply/demand type of market – meaning we must have Commodities to survive every day. Imagine life without energy products for transportation or heating our homes, food products for both human consumption and the livestock that we later consume, textile products for clothing and metals products for construction or jewelry (gentlemen, Valentine’s Day is close at hand, hint, hint). Pricing shares of a stock has nothing to do with production cost, but a Commodity price is heavily influenced by how much it will cost to produce and store that Commodity product for future delivery.
All Commodity prices have minimum and maximum prices based on the production and processing cost of that Commodity. Imagine a Gold mining company having to produce Gold. There are many costs associated with this process such as labor, equipment, taxes, transportation, etc., therefore, to produce an ounce of Gold, there has to be a production cost. Sometimes these prices are referred to as floor prices. In the early 90’s, when Gold was selling for about $250 per ounce (yes, it really was that cheap at one time), the floor price (cost to mine an ounce of Gold) was approximately $250. When market prices do not allow a good profit margin, this forces many businesses to close their doors or mines in this case. The net result is fewer mines produce less Gold and supply decreases worldwide. With less supply of Gold around the world, it takes very little demand to spark a bull market at a later time. Once the demand picks up and prices begin to rise, the mines open again and eventually, they produce enough Gold so that there is sufficient supply worldwide and prices begin to drop. Higher prices always attract more producers of a Commodity and this creates excesses. The cycle repeats itself over in almost every Commodity market like this.
I would like to talk about a market that is at one of the extreme levels currently.
Disclaimer: This is not an investment/trading recommendation. This is purely educational material and should be taken as such.
Natural Gas has been in a bear market for a while and has started to come down into some very long-term demand levels. These levels are approaching what it costs to produce Natural Gas. Figure 1 is a long-term chart, courtesy of Moore Research Center – www.mrci.com.
Figure 1 shows us that when Natural Gas reaches prices between $1-2, the market finds support. This monthly chart dates back to 1991 and shows where the market is flooded with product supply. Now, some 21 years later, we are seeing prices approaching this area. Once this happens and Natural Gas rigs begin to shut down due to decreased profit margins, we should see the next up move in prices when demand reappears. This demand could come in multiple forms:
- The United States is slated to become the world’s largest producer and exporter
- The housing market rebound will create a demand for more Natural Gas to be used for heating due to the low cost
- Currently, there is a threat of war when Iran attempts to shut down the Strait of Hormuz. This is not a question of if, it is a question of when
- The United States’ infrastructure is completed to transport Natural Gas to shipping ports more economically and timely
- The cold weather in the Northeast United States winter season
The above points will all have an impact on Natural Gas prices. When the conflict of the Strait of Hormuz occurs, we will see a price spike in Crude Oil (temporarily, but none the less a spike) and this will result in the world looking for alternative fuels again. It is a shame it takes situations like this to promote a search for alternative fuels, but that is how it is.
For an investor to participate in this market, I would recommend using an Exchange Traded Fund (ETF) and not the Futures market. The Natural Gas market could stay at relatively low levels for an unknown period. Since the Natural Gas Futures contract expires every month and the distant months are not very liquid, this could lead to a higher cost to invest using Futures contracts.
The ETF I would recommend is the United States Natural Gas Fund (UNG). When using an ETF, the investor is not faced with contract expirations or rollovers as they would be faced with in the Futures markets. If an investor finds that they are profiting from their investment in UNG at a later date, perhaps they could use some of the proceeds to invest in some Futures contracts to increase their returns using margin.
UNG trades on the New York Stock Exchange Arca. Unlike some ETFs, UNG is made up of purely Natural Gas Futures contracts, Forward contracts of Physicals and Swap contracts of Physicals. This allows the ETF to track the Physical Commodity rather than companies that produce and process the Commodity. Their objective is to track the price of Natural Gas with minimal management expenses.
Figure 2 is a chart that shows how closely the UNG tracks the Natural Gas Futures contract.
In the past, the UNG has performed miserably tracking the underlying Natural Gas Futures contract. This was mostly due to the fact that the ETF would only use the Futures markets to trade with. The Natural Gas contract expires every month and with each of these expirations, UNG was forced to pay a higher price every time they rolled over an expiring contract. The effect was that UNG kept incurring higher priced contracts that never seemed to catch up before the next expiration came along. Since 2008, after the energy price spike, the Commodity Futures Trading Commission (CFTC) began to enforce position limits on the UNG to limit the number of contracts UNG could buy. The CFTC felt that there was a possibility that UNG and other ETFs were part of the cause of the 2007 energy price spike. To avoid these position limits, UNG has begun using Physical Forward and Swap contracts which do not expire so frequently. This will allow UNG to hold positions longer without the frequent rollovers they incurred in the past. UNG still uses Futures contracts, but this is not the only investment vehicle they use now. Without these frequent rollovers, perhaps UNG will more naturally track the underlying Commodity of Natural Gas.
Using a Commodity ETF in your portfolio is the beginning of true diversification. Just because you have different asset class stocks in your portfolio does not protect you well enough due to the nature of how most stocks rise and fall in tandem. Holding and being educated in different investment asset classes is how a professional investor diversifies their portfolio
Remember that this type of investment is not meant to be an overnight short-term get rich strategy. This could take a while, but as with most good things, it could be worth the wait.
When Commodities get to these depressed levels, it surely deserves a look into an opportunity. If you feel that Natural Gas can go to $0 and eventually go away, then perhaps this is not your investment. For those of us who understand the importance of Natural Gas, we know that the laws of supply and demand will win out as it always does in any freely traded market.
“Experience tells you what to do; confidence allows you to do it.” Stan Smith
Happy Chinese New Year,
– Don Dawson