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Natural Gas ETF Conundrum

2 Comments August 28, 2009 – 3:05 pm |   | Permalink |  Print This Post |

Whilst we have been bullish on Natural Gas (for a while), we have been trying to figure out what is the best vehicle to invest in Natural Gas. We all know better days are ahead, the question is how to exploit this in a way that the returns are at least proportionate to the eventual rise in gas spot prices.

Natural Gas ETFs

The manipulation is obvious, as evidenced by the gross discrepancies between current ($2.80 Sept contract - now expired) and future contracts (was $3.20). Later dated contracts for commodities are normally slightly higher when compared to current contracts to account for the costs associated with storage. This is referred to as Contango. The opposite (Future contract < Current contract) occurs less commonly and is known as “Backwardation” : common causes of backwardation are short term disruptions to production eg bad weather, war etc.

One of the biggest ETFs for Natural Gas is UNG:

United States Natural Gas Fund, LP (USNG) is a limited partnership. The Company is a commodity pool that issues units that may be purchased and sold on the NYSE Arca, Inc. The investment objective of USNG is for the changes in percentage terms of its net asset value to reflect the changes in percentage terms of the price of natural gas delivered at the Henry Hub, Louisiana, as measured by the changes in the price of the futures contract on natural gas as traded on the New York Mercantile Exchange (the NYMEX) that is the near month contract to expire, except when the near month contract is within two weeks of expiration, in which case the futures contract will be the next month contract to expire. USNG invests in futures contracts for natural gas, crude oil, heating oil, gasoline, natural gas and other petroleum-based fuels that are traded on the NYMEX, ICE Futures or other United States and foreign exchanges.

There are several potential “problems” with investing in ETFs.

• UNG invests in rolling contracts for Natural Gas. When the current/nearer month contract expires, they roll over to the next months contract. Now because of significant contango (ie current contract priced much lower than future contract), it is possible that ETFs are losing out. Hypothetically, say we have $100 to invest in Gas. We used this to buy 100 September Gas contracts priced at $1. On the expiry date, we sell off our 100 contracts at $1, and use the proceeds to buy the October contracts which for argument sake is priced at a 100% premium of $2. So we can only afford 50 contracts for October. If the October contracts drop to $1 by its expiry, and the November contracts are again at $2, we can only afford 25 contracts for November. Now a year later, assuming our holdings have decayed to 12.5 contracts thanks to another cycle of contango, price of gas decide to turn around. Prices quadruple from $1 to $4. Our holdings will only be valued at $50 - half of our $100 initial capital despite prices going up four times to when we first started investing in gas at $1. Now that is a problem. Although our scenario is too simplistic, it illustrates how compounding Contangos can affect out NAV. Obviously, the thing which may save us is the reverse - ie backwardation. The same manipulators will have headlines read “Winter colder than expected” or “Hurricane season worst than expected”. So our 12.5 contracts may be sold for $4 for January to realise $50, rolling over to February contracts which may only be $2 (hence we can afford 25 contracts). By expiry, if February goes up to $4 again, we would be back to $100. And if March contracts are again at a discount, say $2, we will roll over with 50 contracts. And if on expiry it goes back to $4, then our NAV is at $200. There is no way of telling how market makers will play this.