In my last article, I suggested investors interested in shorting natural gas via the ProShares UltraShort Bloomberg Natural Gas ETF (NYSEARCA:KOLD) to wait until year-end, as natural gas typically has pronounced year-end seasonal weakness (Figure 1).
Figure 1 – KOLD seasonally strong into year-end (equityclock.com)
So far, my thesis has been bang-on, as the KOLD ETF has returned an incredible 122% since October 31st (Figure 2).
Figure 2 – KOLD has returned over 120% since the end of October (Seeking Alpha)
However, as the calendar rolls over to January, should investors stay with the short natural gas trade?
Brief Fund Overview
First, for those new to leveraged commodity ETFs, the ProShares UltraShort Bloomberg Natural Gas ETF seeks to provide daily returns that are -2x the return of the Bloomberg Natural Gas Subindex (“Index”). The index is designed to reflect daily performance of a rolling position in front-month natural gas futures. As futures contracts expire, the index replaces expiring contracts with those having later expirations.
Figure 3 shows the current holdings of the KOLD ETF, which consists of cash plus short futures positions.
Figure 3 – KOLD portfolio holdings (proshares.com)
For those interested in the KOLD ETF, they should first read and understand this disclaimer from the ProShares website, as well as consult these warnings from FINRA and the SEC (Figure 4).
Figure 4 – KOLD disclaimer (proshares.com)
KOLD Only Suitable For Short-Term Trading
The most important thing to keep in mind with the KOLD ETF is that it is only suitable for short-term trading, as the fund suffers from extreme ‘volatility decay’. Volatility decay occurs due to the daily rebalancing nature of levered ETFs.
For example, assume an investor started with $100 invested in KOLD. If the underlying index returned -5% on day 1, the investor’s holding will grow to $110 (-2 times -5% return). However, if the index returns 5% on day 2, investors end up with $99.00, instead of a 2-day compounded loss of 0.25% or $99.50. This slippage between actual vs. theoretical returns is called ‘volatility decay’.
Since natural gas is an extremely volatile asset class, daily +/- 5% moves are fairly common. So both KOLD, and its corollary fund, the ProShares Ultra Bloomberg Natural Gas ETF (BOIL), suffer from large volatility decays, leading to poor long-term returns.
The KOLD ETF has compounded at a -11.4% average annual return since inception, despite the impressive short-term returns mentioned above (Figure 5).
Figure 5 – KOLD has poor long-term returns (proshares.com)
Warm Weather Led To Yet Another KOLD Bonanza
For a second year in a row, warm weather in North America and Europe have caused natural gas prices to plunge, as one of the primary uses of natural gas is for heating. It is hard to conclude whether warmer than seasonal temperatures were due to climate change, or whether it is caused by the El Niño phenomenon I wrote about in my prior article.
However, the facts are undeniable. According to the latest forecast from the National Oceanic and Atmospheric Administration (“NOAA”), seasonal temperatures are expected to be above normal for most of the northern United States, especially in the North West and North East regions (Figure 6).
Figure 6 – NOAA forecasted another warm winter (NOAA)
This caused natural gas prices to plunge to multi-year lows near $2.40 / mmbtu, and ignited KOLD’s share rally. In fact, KOLD broke out of a multi-month downtrend on November 16th, the day when NOAA’s winter forecast was released (Figure 7).
Figure 7 – KOLD break out coincides with NOAA forecast (Author created with price charts from stockchart.com)
Seasonality Still Favourable Into February
Looking at natural gas seasonality, after a weak December, natural gas typically languishes into February, so there should still be seasonal upside to KOLD (Figure 8).
Figure 8 – Natural gas seasonality still favourable for KOLD into February (equityclock.com)
The technical/fundamental reason for natural gas seasonality is simple to understand. Prices normally rally from August to November as speculators bet on the upcoming winter heating demand, and when actual winter weather occurs, prices decline as reality meets expectation.
But Geopolitics Could Be A Wildcard
However, geopolitics could be a wildcard that supports natural gas prices in the near term. In recent days, European natural gas futures have bounced higher on fears of an escalation in the Israel/Gaza war as the U.S. strikes hostile targets in Iraq and Houthi rebels attack ships sailing in the Red Sea.
As a reminder, with the Russian Nord Stream pipelines destroyed, much of Europe’s natural gas is imported via seaborne LNG tankers from the Middle East. Due to the Houthi attacks, LNG tankers have been re-routed away from the Red Sea, adding over a month to travel times.
If the Gaza war escalates and pull in additional participants, there is a risk that gas supplies will be disrupted, and European gas prices could surge dramatically higher.
Conclusion
The KOLD ETF has recorded yet another bonanza short-term gain, driven by a collapse in natural gas prices due to a second warm winter in a row. Although seasonality still argues for additional natural gas price weakness into February, rising geopolitical tensions suggest traders who caught the surge in KOLD should sell and book their winnings. I downgrade KOLD to a sell.
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