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.