3 Reasons Not to Buy BOIL (or UNG) (2024)

On Sunday, I posted a podcast interview I did with Jason Burack of Wall Street for Main Street in which we discussed the long-term outlook for natural gas and a long list of US natural gas producers.

And back in late January I wrote a piece on natural gas for FMS titled “What’s Next for Natural Gas.”

One common question I’ve received is whether the ProShares Ultra Bloomberg Natural Gas (NSDQ: BOIL) ETF is a legitimate way to play a potential rally in gas later on this year.

For those unfamiliar with BOIL, it’s a leveraged exchange traded fund (ETF) designed to rise 2% for every 1% rally in the Bloomberg Natural Gas Sub-Index, an index of natural gas prices.

At first blush, it seems like a good idea to buy BOIL if you’re bullish gas.

After all, front-month natural gas prices trade around $2.55/MMBtu and my view remains we’ll see gas over $4/MMBtu by early 2024 (or sooner), which equates to upside of about 57%. If BOIL rallies 2% for every 1% move in natural gas, that would seem to imply upside in BOIL of 114%.

However, let me warn you that’s NOT how this ETF works.

It’s important to be careful with leveraged ETFs based on volatile commodities like natural gas — here are the 3 main reasons I prefer to buy producers at this time.

The Importance of Compounding Error

Most leveraged ETFs, including the ProShares Ultra Bloomberg Natural Gas (NSDQ: BOIL) track their underlying benchmark on a daily basis.

In other words, if the index is up 1% in a single day, the ETF seeks to rise 2% in value.

Over longer holding periods, however, the same relationship doesn’t hold due to the effects of daily compounding. Consider a hypothetical index called ABC and an exchange traded fund (ETF) called Ultra ABC that tracks that asset, rising 2% for every 1% daily change in the ABC index.

Take a look at this table of hypothetical price changes over 10 trading days:

Source: Imagination and Basic Math

The starting price for both ABC index and the Ultra ABC fund is $100 and I’ve listed percentage changes for ABC over 10 trading days along with the price of the underlying after each day’s hypothetical trading.

Also listed in the table are the corresponding daily percentage changes in ABC Ultra — on each trading day the price change for ABC Ultra is exactly 2 times that of the ABC Index. So, ABC Ultra is perfectly tracking its underlying benchmark on a 2x daily basis.

However, look at the price changes over 10 trading days and you’ll see ABC index is up 4% to $104, yet ABC Ultra is up just 6%, not 8%.

So while each daily change in the Ultra ABC ETF tracks the underlying index as designed, that does not mean over 10 trading days the return in ABC Ultra is twice the underlying.

I’ve designed a hypothetical underlying index that’s volatile, rising and falling in stairstep fashion over the 10 trading days I’ve listed. However, natural gas is a real commodity that’s infamous for its volatility.

Take a look:

Source: Bloomberg

This is a chart of the Bloomberg Natural Gas Subindex tracked by the ProShares Ultra Bloomberg Natural Gas ETF (NSDQ: BOIL) since the end of 2021.

It’s been a wild ride with this index soaring as much as 165.13% from the end of 2021 to its August 22, 2022 closing peak, only to fall 77.39% from the August 2022 highs to the lows on February 21, 2023.

BOIL Doesn’t Track Front-Month Gas Prices

Before buying an ETF, it’s important to understand exactly what you’re buying.

In this case, BOIL doesn’t track front-month natural gas futures but the Bloomberg Natural Gas Subindex. This index, in turn, tracks gas futures and rolls exposure from one contract to the next month’s contract according to a pre-set roll schedule.

For example, on February 1, 2023 this index was 100% weighted to the NYMEX Henry Hub Natural Gas March 2023 futures contract. On February 8th, the index started to reduce exposure to the March 2023 gas futures contract, rolling into the May 2023 natural gas futures over a period of 5 business days.

As of yesterday’s close, the Natural Gas Subindex held 100% May 2023 natural gas futures. The index will continue to track the May futures until early April when it will roll exposure to the July 2023 futures contract.

A couple of points about this.

First, the front-month natural gas futures contract you often hear quoted in the financial media is the April 2023 futures contract, which is NOT the contract currently tracked by the Bloomberg Natural Gas Subindex or, by extension, the BOIL ETF.

On March 8th, the April 2023 NYMEX natural gas futures settled at $2.551 and the May 2023 contract settled at $2.713, a price difference of more than 6%.

Meanwhile, the July 2023 NYMEX gas futures the Bloomberg Natural Gas Subindex will roll into in the first half of April settled over $3.15/MMBtu on March 8th, more than 23% above the price of the April futures that’s widely quoted in the media these days.

Here’s a look at the futures curve for natural gas over the next three years as of March 8th:

Source: Bloomberg

I see two salient features here.

First there’s a seasonal pattern — natural gas futures prices are higher in the winter months, a period of elevated heating demand, and lower in the spring and autumn “shoulder” season when gas demand is weak.

Second, and more important, this curve has a general upward slope. Thus, April 2023 gas futures are in the $2.55/MMBtu range while April 2026 futures sell for close to $4/MMBtu.

This upward sloping curve is a condition known as contango, and it’s a problem for ETFs that track commodity futures.

Just consider that about a month from now, the BOIL ETF will begin to sell down exposure to the May 2023 futures trading near $2.71 and buy the July 2023 futures which sell for $3.15/MMBtu.

Obviously, we can’t predict exactly where May and July futures will be trading when BOIL starts to roll next month, but there’s a very strong chance those July 2023 futures will have a higher cost than the May futures.

Thus, the fund will be selling a cheaper gas futures contract and buying a pricier contract, leading to what’s known as a roll cost for investors. While ETFs are designed to roll in a way that reduces these costs even small, periodic roll costs can add up to meaningful performance degradation over time.

Incidentally, the same issue exists for unleveraged commodity funds like the ever-popular US Natural Gas Fund (NYSE: UNG).

UNG has a different roll schedule than BOIL. Right now, it’s tracking the April 2023 futures, but starting on March 15th it will roll into the May 2023 futures with the entire roll completed by March 20th. In April, the roll schedule posted here calls for the fund to begin rolling out of April 2023 futures and into the June 2023 futures on April 12th.

And that brings me to this:

Buy the Producers, Not Gas

There are some periods where you might have a strong view on the short-term direction of gas prices and in those instances, commodity ETFs like UNG or BOIL can be an outstanding way to trade that view.

However, that’s not the case for me right now.

My view is that US natural gas prices under $3/MMBtu are unsustainable longer term.

The reason natgas prices are so cheap right now boils down to two points, a warmer-than-average winter that’s reduced heating demand and a fire at a liquefied natural gas (LNG) export facility in Texas called Freeport LNG last June.

The combination of these two factors has led to a glut of gas in US storage.

As per the most recent weekly data from the Energy Information Administration (EIA), the total volume of gas in storage across the US is 2,114 billion cubic feet (bcf) compared to a 5-year seasonal average of about 1,801 bcf, an excess of 313 bcf above average for this time of year.

I do NOT believe this reflects underlying weakness in gas fundamentals.

As I just said, Freeport LNG went offline in June 2022 and maximum daily exports from this facility are around 2 bcf/day. Over the past few days, FERC (finally) granted regulatory permission to restart operations at Freeport and ramp up to full capacity later this month.

However, from mid-June 2022 through roughly mid-March 2023, this plant was offline, meaning the US lost some 400 bcf in LNG exports. Adjusted for that loss of exports, US gas storage would actually be below the seasonal average despite the warm winter.

The US winter heating season is now ending, and market attention will soon turn to summer cooling demand and the consequent draw on gas from electric power producers. If it’s a hot summer, like last year, then gas demand would be elevated, helping the US work off that excess storage.

And, don’t forget the supply side.

Over the past two weeks I’ve read earnings releases, quarterly financial statements and listened to associated conference calls from dozens of US gas producers. Many have decided to cut their drilling activity in 2023 to reduce production due to the collapse in gas prices since last summer. That means less gas supply in the pipeline.

Longer term, the picture is even brighter. Towards the end of 2024 and through 2025, the US is set to put more than 6 bcf/day of new LNG liquefaction (gas export) capacity into commercial operation, which adds to gas demand. And, that’s just plants that are already permitted and under construction — there is a total of some 20 bcf/day of potential new LNG capacity in various stages of permitting through the end of this decade.

The simple fact is that $2.50 to $3/MMBtu is not a high enough price to incentive producers to increase their production of natural gas to meet this growing demand base.

Indeed, $3/MMBtu isn’t even enough to meet gas demand in a “normal” winter for the US and Europe if you adjust for the loss of Freeport LNG exports since last June.

Bottom line: I have conviction gas prices are likely to be much higher, on average, over the next 2-3 years than the current quote or the average price over the 2010 to 2020 period.

That said, the catalyst and timing for gas to rally is uncertain and depends, to a significant extent, on weather conditions in the US and Europe over the next few months.

Clearly buying a gas ETF that owns April, May or July 2023 futures isn’t a great way to express a bullish longer-term view on gas prices or play the late-2024/early-2025 LNG export boom. Thus, I’d prefer shares in a low-cost US natural gas producer.

The Marcellus shale region of Appalachia has the lowest production costs of any major US shale field with some producers in this region able to produce free cash flow even with gas around $2/MMBtu.

In a play like the Haynesville Shale of Louisiana, the breakeven price for gas is higher, usually closer to $3/MMBtu, though gas from this field is ideally suited to supply LNG export terminals due to its geographic proximity to the US Gulf Coast, home to most of the nation’s liquefaction capacity.

So, even at current ultra-low gas prices many US gas producers can still generate free cash flow or, at a minimum, they’re not bleeding cash or forced to take on debt to fund basic operating expenses.

Even better, most producers have modest exposure to current low US gas prices thanks to hedges put in place last year when natural gas prices were much higher.

Hedging policies vary widely by company, but it’s not uncommon to see 60% or more of 2023 production hedged at prices in the $3.50.MMBtu range; last year, when gas prices were soaring, these hedges cost producers money, but this year they’re helping preserve free cash flow margins through the current weak period for US gas prices.

And, look at my chart of the futures curve above. Even today, with spot and front-month gas prices well below $3/MMBtu, the price of gas for delivery in July 2023 is $3.15/MMBtu and for delivery in December 2023 is north of $4/MMBtu — that means many US gas producers could lock in healthy gas prices for their production in the second half of 2023, comfortably above their cash flow breakeven costs.

Producers also aren’t static volume plays. As I mentioned earlier, many are reducing production for 2023 to reflect lower gas prices and profitability.

At the same time, they have the ability to flex their drilling budgets higher in 2024-25 if, as I expect, gas prices generally rise. These additional production volumes will certainly be needed within two years as new LNG export capacity ramps up.

More volume plus higher realized commodity prices equals higher free cash flow.

Finally, producers offer the carrot of cash returns for shareholders via share buybacks and dividends.

Many producers I cover have adopted a base + variable dividend structure. They pay out a consistent minimum dividend plus an additional variable “kicker” that’s based on quarterly free cash flow. Last year, with commodity prices high, this added up to double digit yields from some producers; despite lower prices this year, several are still in a position to pay out mid to upper single-digit yields in 2023.

Others are now focusing on share buybacks, which is a logical means of creating value since stock prices have fallen short-term in sympathy with natural gas prices.

I covered some of my favorite names, and the details of their hedging policies in the podcast I did last week with Jason Burack at Wall Street for Main Street.

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DISCLAIMER: This article is not investment advice and represents the opinions of its author, Elliott Gue. The Free Market Speculator is NOT a securities broker/dealer or an investment advisor. You are responsible for your own investment decisions. All information contained in our newsletters and posts should be independently verified with the companies mentioned, and readers should always conduct their own research and due diligence and consider obtaining professional advice before making any investment decision.