Playing A Natural Gas Breakout (UNG)

By Matthew McCall | May 02, 2007 AAA

Every year around May, the natural gas futures begin to garner more attention than usual. This is due to one thing -- weather. There are two weather situations that drive the volatility of natural gas, warm temperatures and hurricanes. May is the month when we begin to think about both.

Warm Weather and Hurricanes
With the summer season right around the corner, traders are anticipating sweltering "dog-days" that include air conditioners at full blast. Unfortunately, the soothing feeling of fabricated cool air takes energy to produce. Natural gas is power behind many of the air conditioners we so nonchalantly flip to full blast.

Warmer weather results in higher demand for electricity and therefore the price of natural gas will move higher.

Along with sunny skies and warm weather comes hurricane season, which officially kicks off on June 1. Meteorologists from several reputable companies are calling for an above average hurricane season in the Southeastern portion of the United States.

With the majority of natural-gas hubs located in the Gulf of Mexico, any type of strong storm can put a dent in the supply available. Again, it comes down to supply versus demand and a disruption of supply equals higher natural gas prices.

Historically, the price of natural gas begins moving higher in May in anticipation of these two factors. In 2005, the natural gas futures were trading at $6 in May before spiking to $15 later that year. Granted, 2005 was a bad year due to the two large hurricanes that hit the Gulf of Mexico.

However, in 2006 the natural gas futures spiked a quick 20% from mid-May to early June. This short-term rally was followed by a subsequent sell-off to new lows and then an even bigger rally in July. There was no "major" hurricane last year, so futures did not see a sustainable rally. Warm temperatures were not the issue and did give short-term traders two sizable rallies.

Technical Analysis
Natural-gas futures are setting up for a potential major breakout if the meteorologists are correct in their predictions this year. Since the beginning of the year, natural-gas futures have been forming a bullish ascending triangle pattern on the chart.

If natural gas is able to break above the $8 resistance-level, it will result in a new 'buy' signal and could send the futures to the 52-week-high near $9. Looking ahead, if natural gas is able to take out the $9 resistance level the futures may explode as the short sellers run for the exits.

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How to Play a Natural Gas Rally
The first inclination is to open a futures account and trade the natural gas futures. There is one problem, most investors do not have a futures account and lack the knowledge to trade futures.

This is where the new US Natural Gas Fund (AMEX: UNG) comes into play.
UNG is an exchange-traded fund (ETF) that has a portfolio consisting of listed-natural-gas contracts and other natural-gas-related futures, forwards and swaps. The objective of UNG is to mirror the percentage change in the price of the natural gas futures. (To get started, see Introduction To Exchange-Traded Funds.)

Investors must keep in mind that the ETF will be investing in natural gas futures, not the spot price that is quoted in the mass media. The assets will be invested in the front-month contract, and when it expires the money will be rolled into the next available month. This could be beneficial or counterproductive, depending on the situation.

If the price of the futures farther along in time is higher, it results in a situation referred to as contango. When the marketplace is in contango, the ETF must pay more each time a contract is expired and it buys a new one. The current, negative yield due to contango is less than a 2% difference. The ETF also states the collateral assets will be invested in treasuries, which are currently yielding over 5%. This interest will be passed on to investors.

Since UNG was first listed on the AMEX in April 2007, the ETF has traded approximately 100,000 shares per day; not bad for a new ETF. The annual expense ratio will fall between 0.6% and 0.77%. While UNG may not be the perfect fit for all investors, it does allow the average individual an opportunity to play the natural gas futures market.

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