KOLD ETF: Hot Streak May Be Coming To An End

The ProShares UltraShort Bloomberg Natural Gas ETF (NYSEARCA:KOLD) provides -2x exposure to front month natural gas futures. The KOLD ETF has been a big winner in the past few months, as natural gas prices suffered a massive drawdown.

However, with seasonality bottoming out and Freeport LNG restarting, I believe the bearish natural gas trade is nearing its end. Investors who have correctly bet on the KOLD ETF should take the opportunity to lock in their profits before the volatility casino wakes up and takes it away.

Fund Overview

The ProShares UltraShort Bloomberg Natural Gas ETF seeks daily returns that are -2x the return of the Bloomberg Natural Gas Subindex (“Index”). The index reflects the daily performance of a rolling position in front-month natural gas futures. At each expiry date, the index replaces expiring futures with contracts having later expirations.

The KOLD ETF has $150 million in assets and charges an expense ratio of 0.95%.

Please Don’t Buy And Hold

Due to its extreme ‘volatility decay’, the KOLD ETF is not suitable for buy-and-hold investors. It should only be used to speculate on short-term moves in natural gas futures prices.

For example, Figure 1 shows the long-term historical returns of the KOLD ETF, to December 31, 2022. Aside from the short-term 1 month and 3 month holding periods where the ETF has returned 96.9% and 60.1% respectively, every long-term holding period has seen significant annualized losses. On a 1Yr basis, the ETF has lost 88.6%, despite returning 96.9% in December! On a 3Yr basis, the KOLD ETF has lost 67.1% per annum.

The Only Winner In A Casino Is The House

In fact, what is interesting is if we look at the historical performance of the KOLD ETF and its sibling fund, the ProShares Ultra Bloomberg Natural Gas ETF (BOIL), we can see that on longer time horizons, both long (“BOIL”) and short (“KOLD”) investors suffered massive losses. On a 3Yr horizon, the BOIL ETF lost -40.0% p.a. while the KOLD ETF lost 67.3% p.a. (Figure 2).

How is it possible for both long and short investors to lose?

This is possible because both leveraged ETFs suffer from massive amounts of ‘volatility decay’. For example, assume an investor started with $100 invested in KOLD. If the underlying index returns -5% on day 1, the position will grow to $110 (-2 times -5% return). However, if the index returns 5% the next day, investors end up with $99.00, significantly less than twice the 2-day compounded loss of 0.25% or $99.50. This slippage is called ‘volatility decay’.

Natural gas is one of the most volatile assets in the world with a 30-day implied volatility of 134%. Using the rule of 16, this means natural gas prices are expected to move 8.4% per day. So every day, the BOIL and KOLD ETFs are expected to lose more than half a percent in value due to ‘volatility’.

Positive Convexity Boosted Recent Returns

As spot natural gas prices have suffered an epic 70% drawdown in a span of 2 months from its November peaks to a recent low $2.41 / mmbtu due to mild weather, the KOLD ETF has gained an incredible 580% (Figure 3).

This incredible return profile is another ‘feature’ of leveraged ETFs, namely, they have ‘positive convexity’ in the direction of the bet. What this means is that one’s exposure to a given underlying asset grows if the price action is in one’s favour. For example, returning to the numerical example used above, assume you invested $100 in KOLD. If the underlying index returns -5% on day 1, the position will grow to $110 (-2 times -5% return). If the index returns -5% again on day 2, the position will grow to $121. This is more than twice the theoretical 2-day compounded return of 10.25% or $120.50.

However, investors should be mindful that even after an epic 580% rally, the ETF is still trading 70% below its split-adjusted price of $242 on December 31, 2021.

Seasonality Nearing A Bottom

As we begin the month of February, I believe bearish natural gas seasonality is coming to an end. Investors should reduce their bearish bets (i.e. KOLD) if they have any. Over the coming months, commodity traders will start to place bets on the coming summer season cooling demand for natural gas, causing a pronounced March to June positive seasonality in natural gas prices (Figure 4).

Freeport LNG Ramping Back Up

Another reason to pare back bearish bets on natural gas futures is because the Freeport LNG plant is slowly ramping back up to its nameplate capacity. Recall, the Freeport LNG plant has been out of commission since June 2022 due to an explosion. At nameplate capacity, it represents 15% of U.S. LNG export capacity.

A restart of LNG exports out of Freeport LNG should reduce the excess glut of natural gas in U.S. markets, tightening up natural gas prices.

Conclusion

With seasonality bottoming out and Freeport LNG restarting, I believe the bearish natural gas trade is nearing its end. Investors who have correctly bet on the KOLD ETF in the past few months should take the opportunity to lock in their profits before the volatility casino wakes up and takes it away.