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Five Reasons to Stay Cautious with UNG


This market is risky -- consider yourself warned.

I've had lots of questions on my article from yesterday, Tread Carefully When Trading UNG.

For now, I don't plan to do anything with this situation. There are several reasons for this.

1. I have no edge on the regulatory resolution of this.

2. Given the difficulty in shorting shares of United States Natural Gas (UNG) and the particularities in the futures market for natural gas (NG), implementing an arbitrage trade isn't easy.

3. Natural-gas producers are overvalued relative to the spot price. However, if you go out far enough on the futures curve, the overvaluation is still there, but becomes less severe. This contango makes the situation tricky. In theory, the value of producer stock prices should track the prices further out on the curve than the spot price. If the longer-dated prices for NG stay firm, the share prices of producers may not react much. In other words, despite the apparent disconnect between the spot price and the shares of producers, it's possible to argue that producer share prices may be behaving relatively efficiently (I'm trying to say that with a straight face).

4. While it appears that various companies such as Chesapeake Energy Corporation (CHK) and EOG Resources (EOG) are hedged less than 40% (as of last reports) and are therefore vulnerable to the current dislocations, the fact is that one simply has no idea what their trading desks are doing -- or may do. They're as aware of the dangers they face as anybody else.

5. Current hurricane season and the coming winter introduce a risk premium into the market (perhaps a perverse "hope premium) that may support the futures curve out to February or so.

Thus, I'll be staying away from this market for now. However, beware that if hurricane season isn't disruptive and the winter is mild, we can probably expect a major decline in NG prices all along the curve early next year as inventory levels are near record highs and available storage is virtually tapped out. This could devastate the natural gas producer stocks.

A final note. Many investors think that various natural gas plays in the master limited partnerships (MLP) field (pipelines, processors, etc.) are immune to fluctuations in the price of natural gas. In the short term, this may be true in many cases depending on the type of contracts. However, it's not true in the medium term. I'd be wary of this space at this time as any sort of alteration in pricing of contracts will almost certainly elicit cuts in distributions to shareholders. And since virtually all owners of these stocks buy them for the distributions, any cuts in distributions will likely devastate the share prices -- far beyond what would be theoretically warranted.

Consider yourself warned.
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