In my last articleI suggested investors interested in shorting natural gas through the ProShares UltraShort Bloomberg Natural Gas ETF (NYSEARCA:COLD) to wait until the end of the year, because natural gas generally experiences a pronounced seasonal weakness at the end of the year (figure 1).
So far, my thesis has proven to be correct, as the KOLD ETF has returned an incredible 122% since October 31 (Figure 2).
However, as the calendar moves toward January, should investors continue to short trade natural gas?
Brief overview of the fund
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 moving position on front-month natural gas futures contracts. As futures contracts expire, the index replaces expiring contracts with those with later expirations.
Figure 3 shows the KOLD ETF’s current holdings, which consist of cash and short futures positions.
KOLD is only suitable for short-term trading
The most important thing to keep in mind about 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 nature of leveraged ETF rebalancing.
For example, let’s say an investor started with $100 invested in KOLD. If the underlying index returned -5% on the first day, the investor’s holding will reach $110 (-2 times -5% return). However, if the index returns 5% on the second day, investors are left with $99.00, instead of a 2-day compound loss of 0.25% or $99.50. This shift between real and theoretical returns is called “volatility decay”.
Since natural gas is an extremely volatile asset class, daily movements of +/- 5% are quite common. Thus, KOLD and its corollary fund, the ProShares Ultra Bloomberg Natural Gas ETF (BOIL), suffer from significant drops in volatility, leading to low long-term returns.
The KOLD ETF has generated an average annual return of -11.4% since inception, despite the impressive short-term returns mentioned above (Figure 5).
Warm weather led to another KOLD bonanza
For a second consecutive year, warm weather in North America and Europe have caused natural gas prices to fall, with one of the main uses of natural gas being heating. It is difficult to determine whether the warmer than seasonal temperatures are due to climate change or whether they are caused by the El Niño phenomenon that I discussed in my previous article.
However, the facts are undeniable. According to the last forecast According to the National Oceanic and Atmospheric Administration (“NOAA”), seasonal temperatures are expected to be above normal across much of the northern United States, particularly in the Northwest and Northeast regions (Figure 6 ).
That sent natural gas prices plunging to a multi-year low, near $2.40/mmbtu, and sparked the rally in KOLD stock. In fact, KOLD broke out of a multi-month downtrend on November 16, the day NOAA’s winter forecast was released (Figure 7).
Seasonality still favorable in February
When it comes to natural gas seasonality, after a weak December, natural gas typically languishes through February, so there should still be a seasonal uptick for KOLD (Figure 8).
The technical/fundamental reason for the seasonality of natural gas is simple to understand. Prices normally rise from August to November as speculators bet on upcoming winter heating demand, and when winter weather occurs, prices fall as reality meets expectations.
But geopolitics could be a wild card
However, geopolitics could be a wild card factor that supports natural gas prices in the near term. In recent days, European natural gas futures have bounced higher due to fears of an escalation in the war between Israel and Gaza as the United States strikes hostile targets in Iraq and Houthi rebels attack ships sailing in the Red Sea.
As a reminder, with the destruction of the Russian Nord Stream gas pipelines, a large part of European natural gas is imported via maritime LNG tankers from the Middle East. Due to Houthi attacks, LNG tankers were diverted from the Red Sea, extending journey times by more than a month.
If the war in Gaza escalates and attracts new participants, there is a risk that gas supplies will be disrupted and gas prices in Europe will rise significantly.
The KOLD ETF posted another short-term gain, driven by the collapse in natural gas prices due to a second straight warm winter. Although seasonality still argues for further weakness in natural gas prices in February, growing geopolitical tensions suggest traders who have captured the rise in KOLD should sell and reserve their gains. I downgrade KOLD to sell.