Natural Gas ETF Suspends New Shares: Are There Alternatives?

New Shares Suspension

United States Natural Gas Fund (UNG), the world’s largest natural gas ETF, will suspend offering new shares on concerns that federal regulators will keep it from investing in natural gas futures. This decision came after the fund won SEC approval to sell up to 1 billion new units, which would give the fund room to almost triple in size.

This move may keep the fund trading at an expanded premium to its underlying net asset value (NAV), making it more expensive for those retail investors who can only gain exposure to the gas futures market through the fund.

Under Regulatory Fire

In addition, sensing that regulation was imminent, UNG reallocated funds from futures to mostly over the counter ICE swaps. The halt of the new share issuance has broken the tie between NAV and market price, which essentially changed it into a closed-end fund. But the change to swaps alters the nature of the fund entirely. Due to the fact OTC market lacks liquidity, and it’s out of regulatory reach, this generates serious concerns about transparency, and counterparty risk for an ETF like UNG.

UNG is not the only ETF under fire. Leveraged funds such as Direxion Daily Financial Bull 3X (FAS) and Daily Financial Bear 3X (FAZ) as well as ProShares Ultra Short Real Estate (SRS) have also sparked the ire of regulators, skeptical of sales practices. A number of firms, including UBS (USB) and Ameriprise (AMP), have halted the sales of such products to their clients. The scrutiny of these funds has been led by the Financial Industry Regulatory Authority (FINRA).

The Basic Design Flaw

Fundamentally, all ETFs based on commodity futures have a basic design flaw in that they are open-ended funds that invest in futures that are close-ended. This is a major contradiction that is at the source of market dysfunctions.

It comes mostly in a declining price-environment and a contango curve. Contango poses a challenge to funds whose methodologies oblige them to keep rolling futures contracts to maintain their positions. So, with a contango futures curve, every roll registers a loss. UNG units are down about 46% this year, while NYMEX gas futures, which the fund is supposed to track, have fallen about 38% in the same period.

What’s Next for UNG?

Right now, UNG is in the middle of an overhaul and will not go down without a fight. Its rampant growth has been so large that in order to avoid a regulatory clampdown, its portfolio will most likely be shifting more into offshore energy exchanges and swaps. Another option is buying energy futures other than natural gas such as crude oil and gasoline. Whatever the fund decides spells trouble for investors, as the very essence of the fund is changing. Already a sophisticated strategy for even seasoned investors, UNG is about to become more complex.

Investment Alternatives

With new shares suspended, UNG still had the highest asset inflows of any ETF during the month of July, according to data published by Morningstar. However, it is best to stay away from UNG or other commodities ETFs until the regulatory dust settles.

As the near to medium term price momentum is likely to be on the crude oil side as compared to natural gas, investors should consider some of the oil-weighted independent exploration & production (E&P) companies. Almost all E&Ps have aggressive hedging programs in place since they do not have a refining/marketing arm like the major oil companies as natural hedges to their E&P operations.

Therefore, investing in E&Ps with strong balance sheets and international portfolios would be a good hedge for existing UNG holders, or as new investments in lieu of crude oil and natural gas ETFs. Two such companies come to mind: XTO Energy (XTO) and Apache Corp (APA). There is also an ETF - SPDR Oil and Gas Exploration and Production (XOP) that could be a reasonable candidate for your portfolio.

Disclosure: No Positions

Comments

[H. T. Love:]

At $13.00 you can make a little and maybe more. I got in at $13.50 and have no doubt I'll make some *unless* UNG decides to shutdown and return cash.

First, I'm new, so you may wish to discount what I'm about to say.

If your goal is not to get rich quick, but to profit over time, and you are already in UNG, write some calls or buy some puts (we're betting on further price declines) and hang in there while we see what comes about. But you have to work it to profit. Plan your entry/exits for the calls/puts and be disciplined.

As I've said many times, UNG is not an investment, but a trade.

My play is premised on getting in at a "reasonable" price (which you've done), garnering cash while while awating the intermediate-term reversal (you're starting late, but if you work the numbers you may still profit), and cashing out *probably* no later than March or April (depending heavily on what's been "seen" until then).

This depends a lot on winter weather, legislation, drawdown due to improving economy ("heh", as the saying goes) and how fast development drilling and/or un-capping "shut-in" commences.

Needless to say, there is some risk. For some folks the best bet may be to cut their losses and dump out soon.

This week's gas rig count is +7 (but 57% off YoY), normally causing a bearish reaction. But net injection was at the low end (52 Bcf?) of expected, normally bullish. But not low enough for the bulls to come charging, based on the market reaction.

The biggest risk is that the fund collapses totally and returns the NAV to the holders in the form of cash - that'll certainly be a loss. But U.S. Commodity Funds, LLP - the general partner - has lots of cash and equivalents and is working in OTC swaps right now (this adds counter-party risk which used to be about non-existent). What they do long-term will probably be affected by the CFTC decisions more than anything else.

Everyone says it's acting more like a closed-end fund (CEF) now.

Here's how I implemented my strategy.

I prefer to write calls as that puts the cash in my pockets - the least risk. Others buy puts. Knowing the resistance formerly was at $13.50 and the stock worked around there in the past, I bought a couple small positions at that price (this was before all the uncertainty began) and then sold $14 puts for $1.10. This put my effective cost/unit at $12.40 (excluding friction) and if the price of NG rose (unlikely was me feeling) I would get a nice little profit in two months ($15.10 - $13.50 - friction).

I knew that 60% of the time the unit price declined during the 4 day roll period. With the current glut of NG, I felt this would probably go higher than 60%. I planned to close my short calls at a profit during that period and then see what the landscape looked like.

I did that, netting a profit on the original calls of $0.70, making my effective cost/unit $12.80. I then sold $13.00 calls another month out for $0.80, bringing the effective cost to $12.00. This was after the cessation of new unit issuance and I was aware that units would likely begin to trade at a premium - a benefit to me since I already own my units.

Now, the point is to repeat this process of close the short calls and write new ones (commonly called "roll forward" if I recall correctly) until one or two things happen (presuming that UNG survives).

Sep - Jan (and often Feb-Mar) is a traditional time of price rise for NG. It should be muted this year for many reasons, but there should still be enough draw/injection disparity or "extraneous events" to bring NG back above $3 sometime during the winter. If the winter is harsher or economy recovers more strongly, this effect may be enhanced.

With a normal UNG NAV to underlying ratio of 3.45:1, a $3.25 NG price e.g., would give an $11.21 NAV price point to UNG. If the premium over NAV continues to hold around 10% (I have no idea if this is likely), we could expect UNG to trade at $12.33 or so. This is above my current cost (discounting any future short call rolls) and only $0.47 off my cost if I had to close my short calls at $0.80 (unlikely since roll them again during UNG's roll period).

The second thing that should happen is that as winter comes, NG prices squeek higher, rig counts stay down (currently at 2003 average levels) drawdown from storage begins, legislation on NG for transportation finally gets passed (that may be a non-factor or may not happen), ... the contango should be replaced by backwardation for a brief time (I emphasize *brief* as storage is over 20% above normal 5 year range and I don't think economic activity alone will be sufficient to cause a longer-term rise and I don't know what the winter forecast is yet). At this time, UNG will begin to gain contract counts at roll instead of losing them like it does currently. If there is a delay between this situation and the start of injection season (March-April?) or injection start up is low until more development drilling can occur, NG futures prices might rise and UNG NAV could rise an appreciable amount due to the combination of increasing NG price and increased number of owned contracts.

There are also "shut-in" wells that might be un-capped to start injection quickly but I have no idea how many. I do believe that the producers will delay as long as possible to obtain a better price by letting storage get emptied more than normal. I'm sure they're as sick of these prices as any of us.

This intersection of NG price rising and backwardation is the time to either cash out or decide to increase a position, depending on your view. For me, I'll be out unless I see the industry controlling their production more tightly or some of the long-term bullish indicators (legislation) appear.

Go to

seekingalpha.com/insta...

and look at some of the charts there. Maybe they'll help you decide.

I hope this helps,
HardToLove

On Aug 21 05:33 PM oldtenor wrote:

> Thanks for the article & comments.
> Unfortunately, I bought UNG several weeks ago at $13.00.
> Should I sell to take a loss ?
> Thanks for advice.

Aug 21 07:08 PM

[Ricard:]

Very interesting article and comment stream. I'm long term bullish on natural gas, but am not familiar (at all) with this sector. Seems this ETF is not the way to go. Anyone have a list of stocks to recommend for this play?

Thanks.

Aug 21 07:41 PM

[aarc:]

-----------
The author is saying stay out of UNG and better still natural gas futures and other etfs such the canadian's.

NG is a highly volatile commodity (pun intended). Just look at the monthly chart; every year, NG price fluctuates rapidly in massive percentages over very short periods of time. So if you cannot track NG on weekly or monthly basis; you may find yourself rich after several months and poor after less than a year's time or vise-versa.

NG is a buy low sell high or short high cover low for highly active speculators; definitely NOT a buy low/high sell high/higher investment that you can rely on year after year.

So buy UNG while it is being hammered to death or wait for the reversal and chase it up as fast as you can if you can.

As for UNG; either you buy NG futures and pay the extra price of contango spread yourself or let UNG does it for you. Just don't expect UNG to tract NG toe to toe because of the contango (or backwardation for that matter) effect. You will have the same price or P/L differential over an extended period of time if you keep rolling over futures contracts.

Aug 21 08:17 PM

[Dian L. Chu:]

Yes, same issues with $UNG are affecting other commodities ETFs. See "DB Commodity ETFs Face New Restrictions" from Yahoo Finance
finance.yahoo.com/news...
Thanks.

On Aug 21 05:24 PM SouthboroughMAGuy wrote:

> Do the same issues raised here on UNG apply to DBC?

Aug 21 08:53 PM

[Dian L. Chu:]

I would recommend holding $UNG @ $13 long.
If you click and enlarge the graph of the article, you will see I recommended hold if bought below $45.
Thanks for your comment.

On Aug 21 05:33 PM oldtenor wrote:

> Thanks for the article & comments.
> Unfortunately, I bought UNG several weeks ago at $13.00.
> Should I sell to take a loss ?
> Thanks for advice.

Aug 21 09:09 PM

[Dian L. Chu:]

As noted in my article, I recommend oil-weighted E&P companies shares like $APA, $XTO as hedge for current $UNG holdings or as new investments in both the oil and natgas.
I like the ETF $XOP as well.
If you'd prefer natgas-weighted producers, $CHK, $APC, $DVN are all very solid and well-managed E&Ps worthy of a look.

On Aug 21 07:41 PM Ricard wrote:

> Very interesting article and comment stream. I'm long term bullish
> on natural gas, but am not familiar (at all) with this sector. Seems
> this ETF is not the way to go. Anyone have a list of stocks to recommend
> for this play?
>
> Thanks.

Aug 21 09:19 PM

[dwb:]

counterparty risk-> on ICE cleared OTC swaps the risk is essentially the same as NYMEX cleared products. UNG does not face the counteryparty directly though ICE clearing. Liquidity on ICE for the look-alikes is fine. Clearly the author does not understand ICE cleared products.

closed ended-> Since when are futures and swaps "closed ended." wha? USL uses swaps to track "12 month oil". The real risk is that the swaps perform differently than the prompt (that is, if UNG uses 3, 6, 12 month swaps instead of mostly prompt and prompt +1). A 6 month swap will perform very differently than 1 month prompt and is likely to outperform prompt declining prices and underperform prompt rising prices (back months will not rise/fall as much as prompt). For example, suppose there is a hurricane: Oct and Nov production get disrupted so those contracts soar. Dec, Jan, Feb mos are increasingly less likely to be affected and rise less. The increase in a swap will be the avg increase of all those months. If UNG uses 2-month swaps or prompt and prompt+1 then UNG rises the full amount of oct and nov futures increases. If UNG uses a 6-month swap it rises less (the avg increase of all 6 forward months).

On the roll yield, using swaps might actually mitigate the loss in a steeply contango market as less is lost rolling the back month(s) if the contango flattens after 6 months as it does now. Of course, this depends on the term of the swaps and the shape of the contango.

Aug 21 11:32 PM

[H. T. Love:]

Thought it might be useful to know that UNG is taking steps that could affect an assumpton of premium over NAV.

On Aug 21 07:08 PM H. T. Love wrote:

><snip>

> But U.S. Commodity Funds, LLP - the general partner - has lots of
> cash and equivalents and is working in OTC swaps right now (this
> adds counter-party risk which used to be about non-existent). What
> they do long-term will probably be affected by the CFTC decisions
> more than anything else.
>
><snip>

> With a normal UNG NAV to underlying ratio of 3.45:1, a $3.25 NG price
> e.g., would give an $11.21 NAV price point to UNG. If the premium
> over NAV continues to hold around 10% (I have no idea if this is
> likely), we could expect UNG to trade at $12.33 or so.

Over the long haul, we should assume a premium of 0, based on this article.

seekingalpha.com/artic...

HardToLove

Aug 22 06:04 AM

[Dian L. Chu:]

This is the latest on $UNG net asset value that might help: WSJ: $UNG now trading at $12.8% premium snipr.com/qkzwq
I still recommend short $UNG.

On Aug 22 06:04 AM H. T. Love wrote:

> Thought it might be useful to know that UNG is taking steps that
> could affect an assumpton of premium over NAV.
>
> On Aug 21 07:08 PM H. T. Love wrote:

Aug 22 08:47 AM

[Dian L. Chu:]

Here is the latest on $GAZ: Barclays suspends iPath nat-gas ETN issuance $GAZ tinyurl.com/m4ps6u
Thanks for your comment.

On Aug 17 03:13 PM adamnb wrote:

> One etf alternative to UNG is Claymore Natural Gas Commodity Fund
> (seekingalpha.com/symbo...) that trades on the Toronto Exchange,
> trading at about 5 (Canadian).

Aug 22 09:01 AM

[Dian L. Chu:]

Here is the latest on $GAZ: Barclays suspends iPath nat-gas ETN issuance $GAZ tinyurl.com/m4ps6u
Thanks for your comment

On Aug 17 12:28 PM Castrese Tipaldi wrote:

> Speaking of tracking NatGas, why nobody ever notices GAZ?
>
> I guess it's just too cool bidding up the price of an ETF like UNG
> to double digit premium to its NAV, a total non-sense!
>
> An ETF structured like UNG is just a gigantic wealth transfer from
> retail investors (other than aggressive traders) to the Wall Street
> finest.
>
> Just think about the constant roll over: all other futures traders
> know what it has to do and when it must do it.
> Amazing!
>
> Long GAZ, short UNG!

Aug 22 09:07 AM

[Dian L. Chu:]

I replied on $GAZ to the wrong thread.
As for Claymore Natural Gas Commodity Fund, it has been designed to track the performance of the benchmark NGX Canadian Natural Gas Index. The fund will likely be subject to the similiar regulatory issues and market risks just like $UNG and other commodities ETFs.
Thanks for your comment.

On Aug 17 03:13 PM adamnb wrote:

> One etf alternative to UNG is Claymore Natural Gas Commodity Fund
> (seekingalpha.com/symbo...) that trades on the Toronto Exchange,
> trading at about 5 (Canadian).

Aug 22 11:01 AM

[Southboroug...:]

It sounds like you are saying if you bought under 45, then hold. But in general you're saying don't buy UNG, and in fact, short it. How does that all add up if the price is currently under 12?

Or are you saying, short UNG for some tight time frame - next 3 months, but 2-3 years out you expect it to go up?

What am I missing?

Aug 22 01:05 PM

[Dian L. Chu:]

I'm saying if you already bought $UNG at below $45, then hold long, instead of selling at a loss now.

However, if you don't already own $UNG, but are looking to get in on natgas now, then I would advise to stay away from $UNG due to the various regulatory and market risks as outlined in my article. Instead, I would take a look at the E&Ps listed in the article.

For seasoned traders looking to play with the price momentum, I would say short $UNG.

Hope this helps clarify. hank you for your comment.


On Aug 22 01:05 PM SouthboroughMAGuy wrote:

> It sounds like you are saying if you bought under 45, then hold.
> But in general you're saying don't buy UNG, and in fact, short it.
> How does that all add up if the price is currently under 12?
>
> Or are you saying, short UNG for some tight time frame - next 3 months,
> but 2-3 years out you expect it to go up?
>
> What am I missing?

Aug 22 07:01 PM

[Francis Groves:]

I've been following this discussion about 'closed end' in the context of commodity futures contracts and (what Europeans call) exchange traded commodities. I was surprised at Dian's eventual explanation. Her original remark makes perfect sense if you replace 'closed end' with 'fixed term' and 'open end' with 'perpetual'. But these limits on futures contracts are surely only potential most of the time; they can't be said to explain the real paradox of ETC, building a perpetual investment out of fixed term contracts.


On Aug 17 09:07 PM Fivethousandoverlibor wrote:

> Thank you Dian. Appreciate the response. I think it is a misnomer
> to use the term "closed-ended" when referring to futures contracts,
> especially in the context of a currently closed-ended fund such as
> UNG. While individuals and entities can experience limitations on
> their individual participation within regulated futures markets,
> the market in aggregate is not closed-ended. Thanks again for the
> response.

Aug 25 09:34 AM

[ffwpg:]

Is GAS.TO (claymore etf) safe long? Talking head on BNN suggested his firm bought at beginning of summer ( over $6 ). Now barely over $4. How low does it go...out the bottom? I get the feeling folks are being hosed.

Aug 26 11:05 AM

[Dian L. Chu:]

If you already own $GAS, then I would recommend hold long instead of selling at a loss now. North America natgas price should bottom out soon, but in my opinion, the climb back to $6-$8/mmbtu is not likely in the cards for 2010.
Below is a copy/paste a previous discussion thread on $GAS & $UNG for you reference.

"As for Claymore Natural Gas Commodity Fund, it has been designed to track the performance of the benchmark NGX Canadian Natural Gas Index. The fund will likely be subject to the similiar regulatory issues and market risks just like $UNG and other commodities ETFs.
Thanks for your comment.

On Aug 17 03:13 PM adamnb wrote:

> One etf alternative to UNG is Claymore Natural Gas Commodity Fund > (seekingalpha.com/symb... that trades on the Toronto Exchange, > trading at about 5 (Canadian)"

On Aug 26 11:05 AM ffwpg wrote:

> Is GAS.TO (claymore etf) safe long? Talking head on BNN suggested
> his firm bought at beginning of summer ( over $6 ). Now barely over
> $4. How low does it go...out the bottom? I get the feeling folks
> are being hosed.

Aug 26 01:32 PM

[ffwpg:]

Thanks for the response. I was in at about 6.40 and got out after a 16k bath. I see no reason that it continues down even tho' the manager of the fund tried pumping it upon BNN. I could easily be down a further 20k. at this point. Got any ideas of when to get back in? I have noted your other plays such as CVX as an alternative.


On Aug 26 01:32 PM Dian L. Chu wrote:

> If you already own $GAS, then I would recommend hold long instead
> of selling at a loss now. North America natgas price should bottom
> out soon, but in my opinion, the climb back to $6-$8/mmbtu is not
> likely in the cards for 2010.
> Below is a copy/paste a previous discussion thread on $GAS &amp;
> $UNG for you reference.
>
> "As for Claymore Natural Gas Commodity Fund, it has been designed
> to track the performance of the benchmark NGX Canadian Natural Gas
> Index. The fund will likely be subject to the similiar regulatory
> issues and market risks just like $UNG and other commodities ETFs.
>
> Thanks for your comment.
>
> On Aug 17 03:13 PM adamnb wrote:

Aug 27 02:16 PM

[Dian L. Chu:]

$XOM $CVX both have huge overseas LNG operations, and are dividend-paying blue chips. $CHK is the top domestic natgas producer and shale gas operator. $DVN $ECA and other stocks and ETFs mentioned in this article and my next one are all good candidates for your consideration.
Thanks for your comment.


On Aug 27 02:16 PM ffwpg wrote:

> Thanks for the response. I was in at about 6.40 and got out after
> a 16k bath. I see no reason that it continues down even tho' the
> manager of the fund tried pumping it upon BNN. I could easily be
> down a further 20k. at this point. Got any ideas of when to get back
> in? I have noted your other plays such as CVX as an alternative.
>

Aug 28 08:16 AM

[receipt:]

With all the difficulties UNG involves, it's a mystery who anyone would buy it, except perhaps they are unaware of (HZBBF) Horizons BetaPro which is a double long play on natural gas' next months futures.

Sep 14 11:32 AM