ETF Talk: Edouard Spares U.S. Natural Gas Supply

History offers important lessons if we remember what happened in the past and use the information to our advantage. Tropical Storm Edouard offered the latest example of that adage in the natural gas sector. Severe storms that batter the natural gas producing region along the U.S. Gulf Coast typically hurt production and lead to temporary supply shortages. Fortunately, Tropical Storm Edouard did not cause any major damage to the nation’s natural gas infrastructure when it hit the Galveston, Texas, area with heavy rain and strong winds on Tuesday.

It was a welcome development for natural gas companies that have been losing market value in recent weeks. Indeed, two funds that track the sector have taken their lumps during the past few weeks but remain in the black year-to-date.

The United States Natural Gas Fund LP (UNG) only dipped in value by four cents to $40.49 a share on Aug. 5 — the day that the tropical storm struck. The fund’s one-month market return, as of Aug. 5, is -32.35%. Year-to-date, however, UNG is +17.52%. UNG seeks to replicate the performance of natural gas by investing in futures contracts traded on the NYMEX.

The Dow Jones-AIG Natural Gas Total Return Sub-Index (GAZ), an exchange-traded note (ETN) that is designed to reflect the performance of natural gas, dropped 22 cents a share Tuesday, Aug. 5, to close at $53. The decline marked a 32.46% drop in value for the fund during the past month. The plunge provided an indicator of the sector’s high volatility. The downward swing of GAZ is more dramatic when measured against its year-to-date return of 17.01%.

The modest fall in the value of both funds yesterday is a fairly benign result for a sector known for its wild swings. Natural gas is no exception to the general rule that reduced supply of any commodity, amid steady or growing demand, boosts its price. Exogenous factors, such a hurricanes and tropical storms, certainly affect this sector dramatically at times. The following graph reflects that reality.

Recent Growth in Natural Gas Production in
the Lower 48 States Breaks with Historical Trends

For the past several years, the price of natural gas has been in the $6.50-range for the month of July. This year, however, it peaked at $13. In addition, the U.S. Department of Energy warned in July that natural gas bills could be 40% higher than usual this winter.

The federal agency also reported that natural gas production in the lower 48 states has seen a large upward shift. After nine years of no net growth through 2006, an upward trend began. A 3% rise in natural gas production between first-quarter 2006 and first-quarter 2007 was followed by an exceptionally large 9% increase between first-quarter 2007 and first-quarter 2008.

Improved technology, developed in recent years, now allows for the economic production of resources in deep water. High and increasing natural gas prices have spurred more natural gas drilling and a trend to move from drilling simpler vertical wells to horizontal wells.

One indicator of the transition from conventional to unconventional production is the number of rigs drilling "horizontal wells," according to the U.S. Department of Energy. In the late 1990s, about 40 drilling rigs, or 6%, were drilling horizontally. As of May 2008, the number of rigs drilling horizontal wells grew to 519 rigs, or 28% of the total. That increased production suggests that the long-term outlook for natural gas producers is a bit more encouraging than it would have appeared several years ago.

After a run-up in price for natural gas entities since the start of the year, it is not surprising that they pulled back significantly in the past month. At some point the downward trend will reverse. It certainly bears watching and I will be doing just that to try to detect when the pendulum might begin to swing in the other direction.