Natural Gas ETFs: Not a Good Investment

Over the past few months there has been a lot of investor interest in natural gas. The spot price of natural gas has collapsed to under $3 from a high of $14 last year. At the same time crude oil has rallied to a high of $74, from a low of $34.

As a result the oil to natural gas ratio is greater than 22, at historic extremes.

Natural Gas ETFs: Trading as Closed End Funds

This extreme divergence in the oil to natural gas ratio has attracted a lot of investor interest in two exchange traded funds, UNG and GAZ (technically an ETN) which invest in near term natural gas futures. As a result of the huge amount of money pouring in, these funds have hit position size limits with the CFTC and have stopped issuing new shares.

As a result these funds now trade as closed end funds, with a healthy premium to their NAV. As of Monday’s close, UNG trades at a premium of $1.34, almost 12% above its NAV. GAZ trade at a premium of $1.19, about 8% above its NAV.

Natural Gas Forward Curve and ETFs

The natural gas futures market is pricing in a recovery in prices going forward. While the September ’09 contract is trading at $2.945 and the October contract is at $3.362, the December contract is at $5.155, more than $2.20 higher than the September contract. Going out to 2010, the October ’10 contract is at $6.018 and the December ’10 contract is at $6.8013.

Notice how the forward curve is very steep in the near term and flattens out over the next few months.

However, investors buying these ETFs hoping to profit from a rise in the price of natural gas are in for a rude surprise. These funds hold near dated futures. UNG buys the next month’s futures and rolls them over monthly. GAZ buys futures two months out and rolls them over once every two months.

UNG currently owns October ’09 futures and will roll them onto November ’09 futures next month. The November futures are trading at $4.342, almost 23% higher than the October contract. If the roll were to occur today, the number of contracts which UNG will purchase will be 23% percent less than the contracts it sells.

Futures vs. Physical Ownership

The example above illustrates how the NAV of UNG will not go up even though natural gas futures for November delivery are 23% higher than the October futures. This is an inherent feature, called negative roll yield, of any strategy which invests in futures to get an exposure to commodities. A primer for this effect can be found here. The NAV of UNG will not rise unless and until, the entire forward curve for natural gas rises AND the rise gets reflected in near term futures.

On the other hand an entity which physically holds natural gas, can buy the gas at the price of October futures, store it for a month, and earn almost 23% return on the investment.

Limited Storage Capacity: Big Risk of Spot Price Collapse

Since the ETFs use near term futures to get exposure to natural gas, they are highly susceptible to the volatility in the price of near term futures. Currently the spot market for natural gas is very depressed. New production brought online to harness shale-gas is flooding the market, while demand for natural gas is depressed due to the economic slowdown.

As a result the amount of natural gas in storage is much higher than previous years. Due to storage capacity constraints, natural gas producers are being forced to dump the gas in the spot market at highly depressed levels. As a result the spot price of natural gas is under significant risk of collapsing. Some industry analysts say that natural gas spot price could fall below $2 or even $1 in the next two months, till demand kicks in, production slows down or spare storage capacity comes on line.

Any collapse of the spot price of natural gas will be reflected in near term futures contracts and adversely affect the NAV of UNG and GAZ. Further due to negative roll yield, the NAV will not bounce back even if the price a few months out does not collapse.

Difference Between Oil and Natural Gas

The markets for natural gas and crude oil have dramatically different price dynamics. The price of Crude Oil is currently controlled by investor sentiment; it is seen as a hedge against the weak dollar. The infrastructure to store oil is a lot more extensive and global in nature, allowing speculators to ride out any short term supply gluts.

On the other hand, natural gas is primarily a market driven by supply and demand dynamics. When compared to crude oil, international trade and the supporting storage and transportation infrastructure is miniscule.

End customer usage patterns will adjust to massive imbalance in prices of natural gas and crude oil, but this may not get reflected in the spot prices till the supply overhang of natural gas diminishes.

How to Invest in Natural Gas?

Natural gas ETFs not only have a big premium to NAV, they also carry the risk of price collapse of the spot natural gas market. Further they are unlikely to benefit from the rise in the price of natural gas as predicted by the forward curve because of negative roll yield issue. They clearly are to be avoided.

Equity of companies in the natural gas space might be a better investment. The holdings of the First Trust ISE-Revere Natural Gas ETF, (FCG), are a good place to start looking for companies in this area. Due to the collapse of the price of natural gas, many companies in this space have balance sheet issues. So any investment should be preceded by some due-diligence on the fundamentals of the companies.

Many natural gas producers also hedged their production when prices were high and their share prices may already be reflecting that. But any rise in natural gas prices is likely bring in speculative traders back into the natural gas space and should provide a short term spark in equity prices across the board.

For those interested in arbitrage plays, the premium to NAV is less in GAZ compared to UNG. So a long GAZ, short UNG position is worth considering. Do note that GAZ currently holds November’09 contracts while UNG holds October’09 contracts.

Due to the volatility of gas prices, the NAVs of GAZ and UNG will not move in lock-step. Further, since GAZ is much smaller than UNG in size, it might be able to issue new shares sooner than UNG which will shrink the NAV premium faster than UNG.

Disclosure: Vikram actively trades in oil and natural gas related equities and futures.

Comments

[Maxe Paul:]

This is another good article that explains the inherent stupidity of yet another ETF that tries to give an investor a "safe" and " less volatile" way to invest in the "risky" and "volatile" world of commodities.

These ETFs are a failure in all aspects of investing, you simply cannot lesson risk and make a safe investment in risky volatile assets, it just dose not work.

Aug 25 08:08 AM

[Gassy:]

Vikram, Good article. Like you said ideal is to get exposure to physical spot price+storage cost and hold it for 4-5 months and sell the forward to make a nice 23% or even higher. Any way to apply this for individual investors or it is left to BP and Shell to do it. Problem in buying gas companies is that they are more than reflecting high gas prices, almost as the curve. Last time I saw, stocks reflect $6/mcf, hence we are betting on significant reserve upgrades and not the price. There is a diconnect between gas equities and gas prices ytd which remains a threat on gas equities. As the hedges are taken off and gas prices remain low,a number of gas cos will be in trouble. Hence you need to be a "long term" investor in them!

Aug 25 11:12 AM

[staria:]

If you look to explain the huge NAV-premium try this: the shorts are “cornered” by the decision of UNG to halt the issue of new shares and must cover their positions though the stock market. On 14. August the short position in UNG was 13.159.730 shares.

Aug 26 06:00 AM

[User 477290:]

It is important to understant the complexity of commodity ETFs particulary the forward structure as relates to crude oil and natural gas ETFs. However this is no different than investing in physical market where contango is simply cost of storage. For individuals looking for a longer term hold and less exposure to contango there are ETF investment alternatives available in both US and Canada which track longer dated futures. This also offers the ability to be short the front and long the back which has proven to be very profitable in recent months.

Aug 26 09:17 AM

[NGAnalyst:]

Good summary on NG ETFs.

Couple of puzzles to me ---
1. I did a quick comparison of UNG and GAZ. What caused the runup of GAZ between roughly 8/18 and 8/25? which you don't see in either UNG or NGX9 (Nov futures GAZ is supposed to track?)

2. If you look at chart of UNG, you don't seem to see a "sharp rolling loss" around the 4-day roll window in each month beyond the underlying futures price changes (up do down). Does UNG have a mechanism to "spread" the rolling losses across the month?

Aug 26 03:11 PM

[Vikram Saxena:]

NGAnalyst:

1) GAZ was trading without any premium to NAV till they too decided not to issue new shares. Last Thursday (8/20) the news leaked and since then it has built up a healthy premium to NAV which lead to the run its price. The spread between NGX9 and NGV9 has also increased; it is showing up in a percentage change plot of GAZ.IV versus UNG.IV

2) UNG does not lose value just because of the roll. The total value does not change simply because they now own smaller number of contracts at a higher price. However UNG does not benefit from the higher price of the new contract because of negative roll yield. The spread between the two contracts (plot NGV9 - NGU9) widens just prior to the roll date, further short-changing UNG holders.

Aug 28 12:22 AM

[pa68:]

Dear Vikram,
Presumably this analysis applies to lean hogs which might be 35c and likely to make 50c in 4 to 5 months. But perhaps it depends on the length of forward contracts used - is it easy to find out? I am in HOGS at present but found LLHO - the leveraged version difficult to read and higher buy-sell spread.
All the best
Paul

Aug 28 02:38 AM

[azrlindsey:]

Dear Vikram:

I there a futures or options means of taking advantage of the sharp increase in gas price in future months? Alternativley, is there a way to for small investors to buy gas in storage?

Thank you,

Alan

Sep 08 11:21 PM