Natural Gas on Friday (August 21, 2009) closed at ~$2.80/MMBtu – a 7-year low. If we assume that the price will rise to $5 by mid-November of this year, is UNG (the Natural Gas ETF) a good way to play this increase? Here are the key things to consider:
- What does the UNG fund contain? Does it own Natural Gas? No. Instead it invests in future contracts and swaps on the NYMEX and ICE exchanges. On August 11th, it owned the September contracts. The September contracts terminate on August 26th. As specified in UNG’s prospectus, it rolls its contracts 2 weeks before termination, over a 4-day period. This means that for the 4-days starting August 12th, it sold its September contracts and bought October contracts. Currently, NatGas future contracts are under severe contango, i.e. the farther out in time you go, the higher the price. The October price for NatGas is $0.42/MMBtu higher than the September price (which is just $0.02 above the spot price, of $2.78). So, the current spot price needs to rise about ~14% to equal the current price of the October NatGas contract, which closed on Friday at $3.22/MMBtu. In a month from now, UNG will have to sell its October contracts and buy November ones. At that time the spot price will be about the same as the October contract price. If we assume that the spot price moves up to $3.22, NatGas is up $0.42, but UNG has not benefited from this, since the October Futures contract has not moved, by our assumption. Is this an isolated occurrence? Will this happen every month over the next 3 months? Look at the future prices. Today (Aug 22, 2009), the December price is ~$5.02/MMBtu.
- UNG is in a regulatory box. Before July, as the demand for UNG shares increased, UNG’s managers created more UNG shares, and to back them up, they bought more natural gas future contracts and swaps. They did this to keep the price of the shares reflective of the underlying value of the natural gas investments (futures and swaps). If UNG shares traded below the underlying value of the investments, the managers would go into the market and buy back UNG shares (and thereby reduce the outstanding share count), and at the same time sell some of their contracts and swaps. But in early July, UNG hit their maximum share count, 347.4M. They filed to expand this by 1 billion shares, and got permission by the SEC to do so a couple of weeks ago. However, since the CFTC is thinking about imposing restrictions on funds like UNG (because they are neither a consumer nor producer of NatGas), UNG is not creating new shares. In fact, the CFTC may impose restrictions that could force UNG to either resort to offshore trading vehicles or to liquidate the fund.
- There is a difference between UNG’s market price and its underlying value (NAV, or net asset value). Because of the low price of NatGas, many stock investors have been buying UNG. But because the UNG mgt is not creating more shares, the market price of UNG ($11.35) now differs from the value of its current investments, i.e. its NAV, which is $9.94. Every day UNG management posts its NAV. So UNG is currently selling at a 14% premium over NAV. Should the CFTC allow UNG to continue its strategy (or if UNG can switch to an offshore less regulated exchange, or if UNG management decides to liquidate the fund), then the NAV and market price will align. In this case, UNG longs will suffer a ~12% loss, as the market price drops to NAV.
- There is a huge supply of NatGas. This could be a long and complex discourse, and quite frankly I don’t fully understand the complete picture. But I do get the Storage situation. For this, simply look at the gov’t/DOE data. Pay particular attention to the chart. Or more simply, there is far more NatGas in storage than in any August in the last 5 years. For a simplistic commentary on this read these New York Times and Bloomberg articles.
Bottom line. I am bullish on the Natural Gas Prices over the long-term, but bearish on UNG.
Disclosure: I am short straddles on UNG (September and October). But I am short ~3X more calls than puts. In other words, I am hoping that UNG stays below ~$12.50/shr. I would prefer to simply short the stock, but cannot get the shares. I would prefer to simply short the stock, but cannot get the shares from Fidelity (even though the short-interest isn’t high – just ~12M shares vs. 347M outstanding).
