Cave Emptor et Cave Hurricanem

Two part post: Natural Gas admonishments followed by Hurricane Bill admonishments. This one is going to be close, boys.

For those wanting the rapid-fire cliff notes version, FOLLOW Dr.Cane09 on Twitter for regular updates regarding the Tropics, Trading, and misc other weather stuff.

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UNG–Cave Emptor

With September ’09 natural gas approaching $3.00/MMBTU, a level not seen in seven years, one might think that UNG, the ETF that tracks this commodity, would be very attractive, especially with cane season moving into gear. Erroneous!

On July 8th, the UNG Fund ran out of shares due to increased investor appetite that resulted in a volume spike beginning in May.  Looking at Figure 1 below, average daily volume has gone up more than 10x  since the beginning of the year. Total shares issued increased to 281 Million, more than 8x the start of year total.

Figure 1: 1 year chart of UNG showing a surge in volume and an intermediate volume when UNG ran out of shares

Amidst CTIC investigations into  commodity-driven speculation, the fund has not yet re-issued shares. The basic argument regarding cracking down on speculation is this. Approximately a week before the front month contracts expire, UNG sells all of its front month contracts and rolls over those assets into next month’s contracts. For example, this past week UNG has been selling all of its Sept ’09 calls and buying up the same value in Oct ’09 calls. Some believe that massive selling and buying has been driving volatility and should be illegal. It is estimated that the UNG Fund holds up to 80% of the contracts in the front month period. While the SEC last week announced it was permitting the fund to release one billion more shares, the fund is planning to hold off awaiting CTIC clarification regarding caps and restrictions.

As a result of limited shares, the fund has been performing more as a stock rather than as a tracking fund, meaning that it is driven not only by the underlying commodity, but also by investor demand. With a last price right at $12.00, UNG  is now trading at a 12% premium to its NAV, or net asset value of $10.70. In other words, UNG is trading as if the price of September natural gas is about $3.50, rather than the actual $3.10.

Thus, while natural gas may be “cheap”, UNG is actually about 12.5% too expensive. This is terrific if you have been a holder of UNG, as your money has significantly outperformed the underlying commodity. However, if you are a prospective buyer looking to get into the fund, this puts you at risk.

There are a couple of different outcomes in this situation. First, should the CTIC decide that market speculators have not been responsible for commodity volatility and does not plan to impose restrictions, the UNG fund will likely ssue new shares. As a result, the commodity would immediatly revert to its NAV and all shareholders would take at least a 12% haircut. Ouch.

Second, the CTIC determines that funds like UNG are responsible for destabilizing the markets and introduces harsh restrictions and regulations. Not only can UNG not issue more shares, but the fund is too large as it is and must divest some of its assets, or even shut down. As this must be done at the NAV, investors would again lose the 12% premium.

Lastly,  a sort of middle ground. UNG somehow gains permission to issue new shares at the current premium under certain CTIC restrictions. I’m not entirely sure how this could happen within the current framwework of the fund. However, if the premium does remain in place, investor appetite will likely decline as fewer and fewer are willing to pay increasingly high premiums. This might drive the price back down towards the NAV as the market finds itself overwhelmed with shares that are no longer in such high demand.

In conclusion, I still believe that natural gas is undervalued, given the low rig count, production cutbacks, the oil:gas ratio, hurricane season, etc. However, I do not believe that UNG is the best way to play the commodity right now due to the inherent risks I have just discussed. Additionally, the contango, or spread between each month is over 10% for each months. Each time UNG rolls over its contracts, investors thus lose a further 10%.

Rather, I believe that playing individual stocks is the way to go. Since UNG dropped below my cost basis of $13, I have been trimming my position in the fund and have been allocating some of those assets to some big producers, including Chesapeake (CHK) and Southwestern Energy (SWN) during the course of this pullback. Other smaller cap plays such as OMNI and NGAS that are more heavily influenced by the price of NG may be attractive as well. I have also built up my cash position as I believe the market to have downside risk right here. I still have a  position in the fund and will likely continue to hold these shares, but it is not one of my top 5 positions.

In regards to tomorrows supply report, I am projecting an injection of 55 BCF, above the average of 42 BCF, but way below last year’s 88 BCF injection. If realized, it would be the lowest injection of the summer. For a good (yet bearish) analytic discussion of natural gas inventory injections heading into the winter withdrawal season, see CavemanForecaster’s latest post on his blog.

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The Tropics

Hurricane Bill has put on an impressive burst of intensification and is now a dangerous 135 mph category 4 storm. This is about as organized as a storm can get and looks downright gorgeous on satellite. As it enters warmer waters, Bill may continue to intensify further and could approach category 5 strength over the next day or two. Bill has a tropical storm-force wind radius of nearly 400 miles that is generating waves estimated at an almost biblical 80-90 feet near the center.

The storm has finally turned to the Northwest, with a heading of 315 degrees, in response to the trough that I mentioned in my last post. Overnight the the computer models have shifted slightly westward, increasing the potential impacts of Bill to the extreme Northeast coastline. The most westerly models, the NGFDL and the NOGAPS, take Bill within 100 miles of New England.  Shown below in Figure 3 is the GFS model run for Sunday at 8am showing Bill at his closest approach to the Coast.

Figure 2: Latest GFS model run showing Bill side-swiping the Northeast

The explanations and tracks provided in my post last night still hold true, just shifted west. The degree to which the track shifts west will depend on its speed. A faster foward motion would allow it to “beat” the trough to the east coast and move further west before it gets turned away. On the other hand, a slower motion would allow the trough to make more eastward progress and steer Bill away from the coast earlier.

Most of the East Coast will likely see moderate to locally severe beach erosion and Eastern Massachusetts and Long Island will likely see some wind gusts approaching tropical storm force and the occasionally heavy outer rainbands. Fortunately, Bill will not be Category 4 storm at this time, and will probably pass by as a lopsided Cat 1 or Cat 2. Bill will then likely make landfall in Nova Scotia or Newfoundland as a rapidly weakening Category 1 hurricane or strong tropical storm where impacts will again be modest. On a scale of 1 to 10, where a 10 is Katrina and a 1 is Claudette last weekend, I project Bill’s affects on the US to merit a 2.5.  Should the computer models shift any further west, I would begin to get concerned as this is a very large and dangerous storm.

Right now, I see the affects of Bill being similar to to those of Hurricane Edouard in 1996, shown below in Figure 3.

Figure 3: Hurricane Edouard, 1996

Both Edouard and Bill were classic Cape Verde hurricanes. Both peaked as strong Category 4 storms had very large wind-fields. Edouard passed within 90 miles of New England as an 80 mph hurricane doing $6 Million in wind damage and drowning two people. Right now, it looks like Bill may stay further offshore.

Elsewhere in the tropics, the remnants of Ana have entered the Gulf and are diminishing. Re-development is unlikely. A wave off of Africa needs to be watched for development over the next three to five days.

Stateside, the Pacific Northwest has once again entered the sauna. Temperatures in Portland today could approach 100 as a strong offshore flow is pushing hot air down from the high deserts of the interior Northwest. Additionally, the east coast is basking in some of the hottest weather of the summer. Highs in Boston and New York have eclipsed 90 over the past two days. Additionally, the large dome of high pressure that has brought these temperatures is also responsible for stagnating the atmosphere and allowing for a build-up of pollutant-laden haze. Some people may have noticed that it was more difficult to breathe over the past few days.

Warm temperatures and the risk of poor air quality will continue for the next few days until a strong trough of low pressure sweeps through the area Friday afternoon ushering in cooler temperaures. It is this same trough that is forecast to sweep Bill out to sea.

Note II: Major Karma Points to the first person to correctly identify the storm shown at the top.  This is going to be a common theme of posts for the foreseeable future. A small hurricane warning flag will be awarded to the individual with the most points at the conclusion of the hurricane season, provided that they have at least 12.

1. Wabisabi-10

2. DPeezy-9

3. TraderCaddy-4

4. Yogi and Boo Boo-3

5. Jim-1

Disclaimer: Forecasts and Opinions are my own and are subject to error. Please rely on official National Weather Service forecasts.

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