October 9, 2019

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Natural Gas ETF Holders Facing A Brutal Rollover As Seasonal Contango Widens On Pullback; EIA Expected To Announce Bearish Crude Oil Inventory Build But Very Bullish Refined Product Drawdowns In Today's Status Report; Natural Gas Demand To Inch Higher Today, But Realtime Inventories Will Still Top 3500 BCF As Year-Over-Year Surplus Hits +500 BCF

6:00 AM EDT, Wednesday, October 9, 2019
Natural gas prices continued their slow pullback on Tuesday, falling another 2 cents or 0.7% to settle at $2.29/MMBTU. Little has changed over the past 24-48 hours. Much colder temperatures will sweep across the nation later this week, boosting early-season heating demand--but only by so much and only for so long a time. Because it is only early October, even temperatures 20F-30F below-average will only have a limited impact on driving heating demand across most areas. And in areas where it will be legitimately cold--the northern Rockies, the Dakotas, Minnesota--population is limited, and so will be the impact of the chill. Further, the second half of October still looks warmer-than-normal which, coupled with production at record levels, will likely result in end-of-season inventories topping 3800 BCF, more than 600 BCF higher than last year. On the one hand, should the status quo remain and these predictions all verify, it will be very difficult for natural gas to rally here and prices will undoubtedly drift below $2.25/MMBTU, and possibly considerably lower. But on the other, with natural gas down 30% from 2018 and nearly 70% of money manager positions held short, the commodity is vulnerable to a short squeeze should the models switch abruptly and meaningfully towards a sustained colder-than-average late October and November outlook. While there is currently no sign of this, it does introduce a low-probability, but significant element of risk to a short trade. All in all, this makes the natural gas trade--both long and short--very challenging right now.

Of more immediate concern, natural gas ETF traders are facing a brutal rollover. As the Figure to the right shows, the popular 3X leveraged ETFs UGAZ and DGAZ are 40% through closing out its front-month November 2019 contracts and rolling these funds over into the December contract ahead of the November expiration later this month. This rollover process will be completed in the next 3 days. Were the November and December contracts equally priced, these process would have no discernible impact on the performance of the ETFs and I wouldn't bother bringing it up.

However, as Figure 2 to the right shows, there is a significant difference between the November and December natural gas futures prices of more than 20 cents or nearly 10%. This situation is known as contango and, while there is typically some level of spread during the shoulder season as winter prices are usually more expensive than summer prices, recent selling has widened this contango to higher than normal levels. As a result, the ETFs are effectively selling low and buying high, resulting in a long-term price-independent underperformance of the ETFs. The 1x ETF UNG has yet to start rolling over, but will face the same issue in the next 2 weeks. It is worth noting that, as the Figure to the right shows, after Futures prices peak at around $2.62/MMBTU in January--which means another big rollover loss next month as well--prices promptly fall right back to current levels by April 2020. This is known as backwardation and, unlike contango, results in price-independent gains for ETFs. It may be tempting to therefore argue that, yes, UGAZ and UNG will see rollover losses this month and next, but these will be equally countered by rollover gains in the Spring and the whole thing will be a wash. However, should winter temperatures end up warmer than normal and inventories robust, it is likely that near-term contracts will fall over the winter months, greatly reducing this backwardation and mitigating rollover gains next spring. This is a phenomenon that has been seen in winters past and has contributed to the well-document price-independent underperformance of UNG and UGAZ versus natural gas itself. It is for this reason that I prefer to always short the inverse ETF to the direction I am trading--short UGAZ to get short natural gas and short DGAZ to get long the commodity. I take advantage of leverage-induced losses associated with these instruments to counter rollover losses if I am priced long. Click HERE for more on natural gas ETF holdings and natural gas price data.

Meanwhile, oil prices finished slightly lower as the commodity continues to seek direction. WTI dipped 12 cents or 0.2% to settle at $52.63/barrel while Brent fell 11 cents to $58.24/barrel. Amid a lack breaking news to drive prices, investors continued to focus on the ongoing US-China trade dispute.

Traders will, however, get some concrete data today as the EIA will be releasing its weekly Petroleum Status Report for September 28-October 4 this morning at 10:30 AM EDT detailing crude oil and refined product inventories as well as supply and demand data. After the close of trading Tuesday, the American Petroleum Institute (API) announced that it was expecting a +4.1 MMbbl crude oil inventory build. This would be 2.5 MMbbls bearish versus the +1.6 MMbbl 5-year average and would be the fourth straight weekly rise in storage. Inventories would rise to 426.7 MMbbls--the highest since August 23--while the storage surplus versus the 5-year average would climb to +6.6 MMbbls. Year-over-year storage gains would stand at +16.7 MMbbls. However, the relative bearishness of this expected build in crude oil storage would be more than countered by bullish refined product numbers. The API expects gasoline stocks to plummet -5.9 MMbbls, 6.9 MMbbls bullish versus the 5-year average +0.9 MMbbls while distillates are projected to fall -4.0 MMbbls, 2 MMbbls bullish against the -2.0 MMbbl 5-year average. As a result, Total Petroleum Inventories (crude oil + gasoline + distillates) are expected to drop -5.8 MMbbls, a robust -6.4 MMbbls bullish versus the +0.6 MMbbl 5-year average.

Following the API's storage numbers, WTI prices held roughly flat as investors weighed the expected bearish crude oil inventory build versus the very bullish refined product draw. Overall, should such numbers verify, I would view it as a bullish report although I would not be surprised if investors--who tend to myopically focus on crude oil storage data alone--are not quite as optimistic. Long-term, I remain bullish on oil and see no reason to adjust my $65/barrel upside price target. Of course, should US-China trade talks fall apart, the commodity could see further near-term downside, perhaps falling temporarily under $50/barrel, which I would view as a strong entrypoint.

Check back after 10:30 AM EDT on my Crude Oil Inventories Page HERE for the official EIA storage numbers.

Natural gas demand will rebound slightly today as above-average temperatures build across the central and southern US while an arctic cold front prepares to shift out of the Rockies and onto the Great Plains. Across the Deep South, highs will reach the mid-to-upper 80s across much of Texas extending east to Louisiana, Mississippi and western Alabama, all around 5F-10F warmer-than-normal, sufficient to boost very late-season cooling demand. These above-average temperatures will extend northward to set the stage for one final pleasant Autumn day across Minnesota and the eastern Dakotas with Minneapolis, MN topping 70F, 10F warmer-than-normal. Just westward, however, temperatures will plummet with Bismarck, ND not reaching 50F today (around 10F below-average) and Billings, MT only seeing the upper 20s, a massive 35F below average with heavy snowfall that could top 1 foot by storm's end. Below-average temperatures will dominate the region extending all the way to the Pacific Ocean as Portland, OR and Seattle, WA will only see the upper 50s to near 60F, 5F-10F below-average. On the other hand, temperatures will be much more seasonal across the major population centers of the East as a nearby coastal system brings showery conditions. Highs from Washington, DC to New York City will only reach the low 60s, a demand-neutral 5F-10F cooler-than-normal. Overall, thanks to the encroaching arctic air across the Plains, today's forecast mean population-weighted nationwide temperature will cool -1.2F from Tuesday to 63.6F, still 1.0F warmer-than-normal. Total Degree Days (TDDs) will inch higher to 6.5 TDDs, still 1.1 TDDs fewer than normal and the 13th fewest for October 9 in the last 38 years since 1981. Click HERE for more on today's temperature and degree day outlook.

Based on this forecast and early-cycle pipeline data, I am projecting a +17 BCF/day daily natural gas storage injection today. This is 2 BCF smaller than Tuesday's build but still a bearish 5 BCF larger than the 5-year average. By early morning, projected Realtime natural gas inventories will top 3488 BCF, topping the end of season mark from 2008 and vaulting 2019 already up to 11th place on the all-time list with at least another month left in the injection season. By tonight, inventories will reach 3503 BCF, the first time that storage has topped 3500 BCF since December 13, 2017. The storage surplus versus the 5-year average will reach +21 BCF while the year-over-year surplus will top +501 BCF, the first time it has been over +500 BCF since July 3, 2016, more than 3 years ago. Click HERE for more on today's projected storage injection and Realtime natural gas inventories.