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Problems with Natural Gas ETF

2 Comments November 22, 2009 – 2:02 am |   | Permalink |  Print This Post |

Natural Gas ETF Flawed

Natural gas ETF is still down ($0.48) whilst the NYMEX spot price is significantly higher ($4.42) than the lows at $2.40. The value contained within is gradually eroded by the constant contango effect - here is what we wrote in August 2009:

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.

We will look to exit our natural gas ETFs on rebound. We have gotten out half in our personal portfolio (we were over-leveraged!) at $0.62. If Agriculture ETF is anything to go by, the Natural Gas ETF could range between low 40c to mid 60s for up to one year before breaking out.

Agriculture on a Launching Pad

Agriculture on a Launching Pad

The other problem with Natural Gas ETF is the value of UNG is currently greater than the NYMEX gas market - hence many believe UNG is moving the spot price. Excess funds not invested in Natural Gas are being invested in alternative green energy - which is probably a good investment fundamentally but may not necessarily reflect the price of Natural Gas.

We are still looking for the perfect investment for Natural Gas - we know one thing for sure, gas prices will go higher than the current $4.40.