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As seen in the following table of returns provided by Seeking Alpha, shares of the United States Gasoline ETF (UGA) seem to have formed a short-term bottom with prices appreciating after a month of declines.
It is my belief that the current supply and demand balance for gasoline as well as the rolling factors of gasoline futures makes for an excellent purchase of UGA at this time and that higher prices are likely to come in the future.
The Instrument
Let’s start with a discussion about what exactly UGA is so that we can understand where the risks and returns of the instrument come from. To begin with, UGA is an ETF provided by USCF Investments that gives simple and straightforward exposure to gasoline futures contracts. At present, this methodology has the fund holding 461 contracts of September gasoline futures which settle in New York Harbor.
UGA follows a very simple method of rolling exposure between contract months in that in a period of time roughly two weeks before the expiration of the prompt RBOB contract, the ETF will sell its exposure in the front month and shift it to the next month. This methodology results in something called “roll yield” which is perhaps one of the most important things to consider when making an investment decision in UGA.
Roll yield is the gain or loss that an investor earns which is attributed to the fact that futures prices tend to converge to spot prices as time goes on. How this works is that if you are holding exposure in a futures contract in a month other than the front month contract, as time progresses the price of the contract you hold will tend to gradually approach the front month price.
This gradual approach towards the front month contract has pretty strong implications depending on the structure of the market. When a market is in backwardation (a state in which the front contract is more expensive than the back contracts), roll yield on a long investment will be positive since as time progresses the long position established at lower prices will increase in value to approach the front month price. When a market is in contango (a state in which the front contract is cheaper than back month contracts), roll yield on a long position will be negative since the long position established at higher prices will decrease through time in relation to the front month contract.
In the case of UGA, it follows a process in which it rolls exposure roughly half of the way through the month into the next month out. This means that for around half of the month, the return of UGA is both a function of the general price direction of RBOB futures as well as whatever structure is built into the market.
Here is a five-year range of the differential between the front and second month contracts of RBOB futures on a weekly basis.
There are a few things to point out about this chart, but let’s start with some basic tendencies. First, there is a general trend in gasoline markets for the futures curve to be in contango in the first three months of the year and then switch into backwardation for the rest of the year. The reason for this is that peak demand for gasoline comes in the summer months and the forward curve is a statement regarding prompt supply and demand for the commodity, so during periods of higher demand, the front contract tends to price above the next contract out.
The next thing to point out in the chart is the consistent seasonal pattern seen in the futures curve around the ends of winter and summer. The reason for this is that the specifications for a deliverable barrel of RBOB change in these periods which has implications for the value of a barrel of RBOB during these windows. There is a good deal of nuance here, but to begin to understand it, I’d suggest reading the CME’s contract specs document if you want more (the key term is Reid Vapor Pressure and a PSI requirement can be seen in specific months of the year).
For holders of UGA simply looking to capture roll and gain exposure to the trends of gasoline prices, the technical details aren’t that important, but certainly can help gain insight into price movements of the ETF. Perhaps what is most important and relevant to holders at this moment is the current strength of the roll yield which UGA is poised to be exposed to when its roll begins. In a matter of days, UGA will begin rolling exposure into October futures which are currently $0.20 per gallon above September futures which means that roll yield is likely to be substantial.
Gasoline Fundamentals
In terms of gasoline fundamentals themselves, I am strongly bullish the commodity due to a few simple facts.
First and foremost, the five-year range of inventories is not terribly impressive in and of itself.
Gasoline stocks have approached multi-year highs after a strong drawdown in the first part of the year. In a simplistic world, we would call this bearish. However, there are few key bullish factors which indicate that stocks are likely to draw very soon once again.
Firstly, the global market has shown that at these current prices, it is unwilling to import gasoline into the United States.
This means that gasoline prices in the United States will need to expand such that exporting countries will be incentivized to ship barrels. And there is a structural underlying fundamental reason which clearly shows that this adjustment is going to happen: the United States needs the barrels.
As demonstrated by many weeks of above-range imports this year, the United States is short gasoline. However, a few weeks ago, the Northeast lost a sizable chunk of refining capacity in the PES refinery explosion. This lost capacity represents over 30% of the capacity along the East Coast (which is where the RBOB contract actually prices), which means that this region is likely to remain short on gasoline for some time. As long as the region remains short, the price of gasoline will have to generally trend higher to incentivize the flow of barrels into the region. This, combined with the positive roll seen in futures contracts gives strongly bullish tailwinds to the long gasoline trade. It’s time to buy UGA.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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