Revised Strategy for Energy ETFs

So much has changed in energy ETF trading, I feel obligated to write a follow-up to my previous article on the topic. That article, in February 2009, outlined the potential for a relatively safe investment in energy by buying and selling calls on energy ETFs. This was based on the premise that oil and gas were relatively cheap, limiting downside risk. At the same time, relatively high expectations for future prices made it possible to profit by selling call options, while further insuring against the downside. The example I gave involved buying USO and selling 6 month options near the purchase price. As it turns out, all of these options have now been exercised, resulting in a tidy 20% return over a 6 month period, although, of course, owning USO without selling the options would have resulted in even larger gains. But, my objective was good returns for “safe” money…alternatives to low yielding CDs or dangerous bond funds. This objective made the options a critical part of the equation.

While I believe safe, profitable trades are still available in energy ETFs, it is important to note that much has changed since those days:

· Oil has nearly doubled in price, with the result that USO is no longer comforted by the idea that oil prices have little downside. Recent history makes it clear that prices well below current prices are possible, and oil is nearer the upper end of my long term target range than the lower end..
· Natural gas prices, on the other hand, have continued to fall. Over the past few months, I’ve become convinced that natural gas is the energy source with minimal downside due to unsustainable low prices. Therefore, I’ve switched to using UNG as the vehicle for trades. I recently bought UNG at 9. 10. 11 and 12 dollars per share, again selling options just above the purchase price for approximately a 15% premium.
· At recent prices, gas is at multiyear lows, both on an absolute basis and relative to oil.
· But, ETFs such as UNG have become so large that they dominate gas trading, and therefore have problems that make them hard to run efficiently. Recently, UNG has sold at significant (20-25%) premiums to their Net Asset Value. Although currently premiums have shrunk to a more manageable level, it is unclear whether UNG will be able to operate effectively in the current environment. Caution and recognition of this issue is advised

You should also be aware that natural gas has its own peculiarities. Unlike oil, it trades on a more localized, rather than worldwide, basis due to transportation difficulties. This makes the price more subject to local economic conditions. While I expect that over time the U.S. market will come to depend more heavily on LNG, raising prices due to processing and transportation cost and linking the U.S. more closely to world markets, this is not currently the case.

Both supply and demand are significantly effected by the transportation and portability issues of natural gas. Shortfalls cannot easily be covered by importing gas from other areas. Surpluses are difficult to store. Gas is difficult to use for transportation, one of our largest consumers of energy.

Natural gas is considerably cleaner that other hydrocarbons. Over time, I see a move toward natural gas from coal and oil. I also see gas moving toward a more worldwide market. All this will result in higher prices But this progression will be slow, and for now supply exceeds demand in the local market, pushing storage to its limits and pushing prices lower. Now is the time to take advantage. Just be aware of the issues with both UNG and natural gas in general and be cautious.