How To Profit From The Polar Vortex

To profit from the short-term openings the market hands you, it takes the right strategy.

That's a lesson I had to learn after correctly predicting that the U.S. would be in for a remarkably cold winter. Though temperatures in much of the U.S. have fallen to the lowest levels in years, the stock picks I suggested simply didn't have enough leverage to weather as I anticipated. As I noted in late December, those picks rose only modestly as winter dug in, even as natural gas-focused exchange-traded funds (ETFs) fared a lot better.

The explanation is straightforward. As I noted last month, "Many energy traders don't trust quick moves in energy prices, and they assume that profit-taking will soon ensue. If gas prices move back below $4 per thousand cubic feet (Mcf), then these companies will generate a lesser benefit."

Since then, natural gas prices have kept surging, and these stocks still haven't budged much.

Yet a change in the weather provides a shot at redemption. Those rapidly surging ETFs appear set to reverse course, and you can even invest in this strategy without initiating a short sale.

Plunging Storage

The surge in gas prices is due to rising gas consumption, which is depleting storage levels at a rapid pace. Though we typically see winter drawdowns, this winter's weather has led to an exaggerated move. According to a recent article by Bloomberg, natural gas inventories fell 50% from Oct. 31 through Jan. 17. They've surely fallen even further since Jan. 17, as it has been extremely cold in the Eastern U.S. in recent days as well.

Yet that's all about to change. Though temperatures are likely to remain below trend through Jan. 29, they are expected to steadily rebound after that. New York City, for example, is expected to have highs above freezing in the subsequent period, which will feel downright tropical for bundled up Gothamites. That won't quickly eliminate the current gas storage deficits. Producers will be working for months to rebuild inventories. But you can bet they will pump all the gas they can, until prices fall below $4 per Mcf. Meanwhile, electric utilities that can operate on a dual-fuel basis will crimp demand by switching back to coal.

As a result, the remarkable surge in gas prices is likely in the late innings, and it's too late to play this trend for further upside. Instead, as temperatures revert to normal levels, and the hot money flows back out of this trade, bearish ETFs should score quick gains.

To find potential winners, you merely need to seek out recent losers. For example, the ProShares UltraShort DJ-UBS Natural Gas ETF (NYSE: KOLD) has lost half its value in the past three months.

This is a "2x inverse" fund, which means it moves at twice the rate, in the opposite direction, of the underlying commodity it aims to track.

Investors feeling especially emboldened about this trading opportunity should check out the VelocityShares 3x Inverse Natural Gas ETN (Nasdaq: DGAZ), which has plunged from $17 in early November to a recent $4.50.

Risks to Consider: These two gas funds should be used as short-term trading vehicles and not long-term investments, because they "leak" value as monthly contracts are rolled over.

Action to Take -- Natural gas prices are now at four year highs, though as we've mentioned on a number of occasions, the $5- to $5.50-per-Mcf area likely represents a top of the trading range, as producers have much greater incentive to boost production. Dormant wells won't be put into production this week, but the futures market anticipates they would come online in coming months.

The futures prices for June 2014 currently trade at $4.37 per Mcf, while the June 2015 contract is priced at $4.03. Contract prices for delivery in 2018 are in the same area. In other words, the current surge above $5 may continue for a bit longer as storage levels continue to deplete. But a lifting of the polar vortex means this trade looks set to reverse course.

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