Natural Gas ETF Premium Reaches 20%: Time to Unload?

The U.S. Natural Gas Fund (UNG), which has been in the news constantly as the CFTC weighs its options for curbing what it deems to be excessive speculation in the commodities markets, continues to defy the tenets of rational investing. The fund opened Monday at a 20% premium to its net asset value, meaning that the market value of all outstanding shares was about 1.2 times the market value of the fund’s underlying assets. Regardless of the next steps taken by the CFTC or the future of regulation in the commodity industry, the current premium on UNG is not sustainable, and any logical investor with an interest in UNG would be well served to liquidate his or her position.

Behind most exchange-traded funds is an arbitrage mechanism that prevents market prices from deviating from the net asset value of a fund’s underlying holdings. Since the assets underlying most ETFs are securities traded in the open market, if a material disconnect arises between an ETF and its net asset value, an arbitrage opportunity will arise and quickly be exploited by large market participants.

On the Eight Day…

Most investors don’t take time to think about where shares of ETFs come from, but this creation process is crucial to maintaining liquid, constant markets for these securities. For most funds, new shares will be issued to Authorized Participants (APs) in exchange for a specified portfolio of equities comprising the index underlying the ETF. Generally, shares are issued in blocks of 50,000, thereby limiting the universe of investors able to participate in this creation process. Likewise, most ETFs can be redeemed (in groups of 50,000 shares) in exchange for a basket of stocks that approximates the holdings of the index on which an ETF is based.

So where did this process break down in the case of UNG? First of all, UNG is a commodity pool, which means that the creation process is slightly different. Most notably, UNG must receive approval from regulators before issuing new shares at certain levels. As the number of investors looking to make a play in natural gas surged earlier this year, UNG quickly hit one of these share thresholds, and filed for approval on additional share creations with the SEC.

Rather than approve the request in a timely fashion, the SEC delayed its decision (which is very different than denying the request) for some time, perhaps waiting for the Commodity Futures Trading Commission to come to a decision on potential regulations for the industry. The CFTC became concerned earlier this year that ETFs providing exposure to “commodities of finite supply” (basically oil and gas funds) were facilitating speculation in these markets. Such behavior would leave the potential for increased volatility and prices that don’t necessarily react to fundamental supply and demand data.

It is widely anticipated that the CFTC will establish position limits, which (as one might guess) limit the number of futures that any single investor or fund may hold. But exactly what the position limits will be remains to be seen. The fear at UNG is that the fund in its current state will exceed the CFTC’s limits. For this reason, UNG has held off on issuing more shares, even though it did ultimately receive SEC approval to do so.

Where Do We Go From Here?

The future of commodity ETFs is murky at best, but it’s becoming increasingly difficult to imagine a scenario that justifies paying for a 20% premium on UNG. Matt Hougan at Index Universe recently authored an excellent article postulating on the performance of UNG under five of the most likely scenarios. Some of these scenarios would result in either an immediate or gradual dissolution of UNG’s premium to NAV, which is bad news for current investors. But then again, Mr. Hougan penned this piece when the premium was around 11% two weeks ago. It’s since nearly doubled (the premium to NAV that is), rewarding those who decided to hold on to UNG.

Even if position limits do limit the creation of additional shares and “justify” a premium to NAV, I have a hard time believing that the premium will stay at its current level for long. Closed end funds, which lack the efficient arbitrage mechanism of ETFs, rarely trade at a premium or discount of more than 500 basis points. Moreover, innovation in the financial space is nothing new (as evidenced by the development of the ETF industry). If demand for natural gas investments continues to outpace supply by such a wide margin, we can expect that additional funds, or perhaps new investment vehicles altogether, will pop up to satiate the demand.

click to enlarge

Disclosure: No positions at time of writing.

Comments

[Mad Hedge F...:]

Definitrely! “When do I buy natural gas” is the most frequent question I am getting from clients these days. I can’t blame them, after watching CH4 dive from $13.50/MCF last year to a September contract low of $2.72. Massive new discoveries and an unusually cool summer is causing a looming storage shortage that has hammered longs. Those who dove in early have been punished, with stop outs followed by stop outs. The bizarre thing is that gas went up in flames while crude more than doubled, from $32 to $77, leaving pros stunned and speechless. The crude/gas ratio has soared to an unimaginable 27 times, up from a mere four times in the last decade. On a BTU basis, gas is now only 25% the cost of oil, it burns cleaner, with only half the carbon dioxide output, and is cheaper than high grade coal. Natural gas at these prices is another way of buying oil at $18 a barrel, with less pollution. Industry insiders don’t see it falling below $2/MCF, the breakeven cost of the longest term producers, where the shut off valves will start creaking en masse. Existing gas fields deplete at 25% a year, and the 60% cut in new drilling this year will deliver a rebound in prices by next winter. Longer term, the Pickens plan and the conversion of a large part of our national power generation to natural gas will drive prices higher. In the end, I think the final low will be defined by another Amaranth type disaster, where a super leveraged long hedge fund gets wiped out and is then liquidated under the worst conditions imaginable. In 2007, the Amaranth debacle took gas from $17 to $4 in the blink of an eye. Where Amaranth 2.0 will take us is anyone’s guess. But when it happens, possibly as early as September, other big hedge funds will stampede in like feral cats lapping up spilled milk. If I lived over a giant salt cavern, I would be pumping it full of natural gas now. But since these formations don’t exist in Northern California, I shall have to content myself with the futures markets, where longer dated contracts are selling at big premiums. Email me at madhedgefundtrader@yah... if you need help getting set up on the futures. For those not looking for an “E” ticket ride, it may now be time to Hoover up the leveraged natural gas equity plays like Chesapeake (CHK), XTO Energy (XTO), Southwestern (SWN), and Petrohawk Energy (HK), which appear to have already bottomed.

Sep 01 04:15 PM

[Barbarous R...:]

Not only is the premium to NAV at ridiculously high levels, but the NAV itself is poised to deteriorate materially in the short term due to the poor fundamentals for the commodity (storage will be filled shortly) and the steep contango (contract rollovers will be very costly).

Anyone who feels the pressing need to own a natural gas ETF here is at least better off buying the leveraged HNU in Canada at no premium (although it too is likely to be a loser).

The better play is to buy gas-related stocks such as drillers or pressure pumpers -- unlikely to get hit as hard in the near term, and much more leveraged to a gas recovery.

Sep 01 04:29 PM

[BillV:]

Hmmmmm. Mike Turner of streetauthority.com just sent me a email letting me know his next BIG (and only) BUY while he is selling every-thing else he owns. It's UNG. Imagine, a PRO buying at a 20% premium with nothing happening to gas prices for quite some time (I would guess). And there's still alot of overhang in supplies while a few large companies are still sucking gas out of the ground. Boy, am I dumb!

Sep 02 12:25 AM

[mn33:]

it always cracks me up when these blogger boys make up these fancy company names like 'IndexUniverse' and call themselves 'president' and 'editor in chief'.


look at the 'president's background info. alot of blogging and a stint in the peace corps. wow

www.indexuniverse.com/...

Sep 02 01:04 AM

[Mike L:]

Yes , time to unload. Now..or any day over the past year, the further back the better!

Sep 02 03:24 AM

[Moochacha:]

If natural gas is currently trading at record lows then why would the CTFC be concerned about more demand, i.e. UNG issuing more shares? ETN's buying more contracts is certainly not what has driven the price of natural gas down. If they are concerned it seems more likely they would be concerned about what might possilbly be driving prices down artificially, is the increased volume due to selling or buying? So is there any possibility of a short squeeze, hmmm. Don't know but I don\t think prices can go much lower so I am long GAZ.

Sep 02 05:00 AM

[Reagan12:]

Gee....the author continues to pound the drum on this on an almost daily basis. Just how big a short interest does he have? What we have is an opportunity to accumulate blocks of UNG. Put it in the meat locker and worry about something else for a couple years. ETF's aren't designed for a three day trading horizon.

Sep 02 08:27 AM

[WPSPIKER:]

I've heard it both ways, so now what, some say anything below 11.00 is a strong buy, did anyone see what the oil EFTs are trading at for %?

go figure, that it is a big game,

mark

Sep 02 08:40 AM

[receipt:]

One way to go long natural gas is Horizons Betapro NYM Natural Gas Bull (HZBBF) currently below $2.00/share.

Sep 02 08:43 AM

[Stockgobblin:]

When everybody and their mom is saying sell, I do the opposite.

Sep 02 09:18 AM

[daniel3582:]

The question shouldn't be: is it time to unload... the question should be, "What in the world would have ever prompted you to go long?" Fundamentals are terrible. There are also no valid technical buy signals on any time frame, including my specialty, DeMark's signals.

If you really want to go long in NG, open a futures account with Think or Swim. Forget this ETF stuff.

Sep 02 09:24 AM

[Neal Barkett:]

The big question is why is Nat. Gas not being used for a real National Stimulus Package. Washington is blind our just not seeing the forest because of the trees (tunnel vision on alternative fuels is great but 10 to 15 years away as a main supplier) Why are we sending Billions overseas for oil? We could put people to work by installing the infrastructure to get Nat. Gas to the consumer with tax incentives to change cars over to CNG. The price is cheap, the money stays here and best of all it is sooooo much cleaner than coal, or gasoline. What am I missing? A country is strong as its natural resources and with the new discovers of Nat Gas & tech. of exacting it , along with the fact that it doesn't need to be processed by a refinery. I have to believe that OPEC has money being spent to squelch this idea by sending money & influence to Washington! Oh, did I leave out NATIONAL SECURITY? Sorry. Our politicians are not here to serve us ,they are self serving.

Sep 02 09:48 AM

[p church:]

You got it Neal. The reason is because Obama has surrounded himself with some real crackpot people....

Sep 02 10:12 AM

[tedstr:]

Looks fairly simple to me.

Look at the LNG shipments. They're not stopping. Foreign producers just keep em coming and we have the new terminals to take it.
Meanwhile industrial demand for gas and electricity is down significantly.
Add in a developing shortage of storage capacity.
Throw in a dash of the evil squid manipulating the markets and compounding the short

Mix thoroughly and voila you get < $2.00 for NG.

CFTC will now turn on the oven and set for position limits. Insert the UNG ETF and bake for about 1 hour.

Remove from oven and sprinkle lightly with winter seasoning

Short squeeze. Nicely rising back to something that gets closer to the oil price tracking history and a well baked squid that will be delicious for all who dine with them

Sep 02 10:36 AM

[User 305589:]

I tend to agree with mad hedge Fund trader here that stock plays like chk and xto - and i would add mcf - are attractive plays here, likely better than UNG. But, i think one has to put things in perspective here. 20% premium above NAV is of course, a big number. however, for many people there are few alternative options available to directly play NG. IF and when NG bottoms here anywhere between 2.50 and 3.00$ it has the potential to easily go up towards $4/$5. And longer term, well, $7 or $8 certainly are reasonable targets a few years out. the 20% premium paid now may not matter that much in the larger scheme of things. and of course you could just built some call-spreads on ung and eliminate much of that 20% premium problem alltogether...

Sep 02 10:59 AM

[optionsgirl:]

i'm just going to hold my small position and keep selling calls. look at where nat gas is on the back months.


On Sep 02 10:59 AM User 305589 wrote:

> I tend to agree with mad hedge Fund trader here that stock plays
> like chk and xto - and i would add mcf - are attractive plays here,
> likely better than UNG. But, i think one has to put things in perspective
> here. 20% premium above NAV is of course, a big number. however,
> for many people there are few alternative options available to directly
> play NG. IF and when NG bottoms here anywhere between 2.50 and 3.00$
> it has the potential to easily go up towards $4/$5. And longer term,
> well, $7 or $8 certainly are reasonable targets a few years out.
> the 20% premium paid now may not matter that much in the larger scheme
> of things. and of course you could just built some call-spreads on
> ung and eliminate much of that 20% premium problem alltogether...

Sep 02 11:15 AM

[Kirk Spano:]

While I have traded UNG a few times, I have not established a big long position as of yet, though I did buy CHK under $20. At some point, I agree with mad hedge fund trader, some event, I once again agree quite possibly a large investor biting the bullet, will cause the trough in nat gas, somewhere around $2-2.50, maybe even a shade lower for an hour or two. Because UNG isn't tracking perfectly, we'll have to make imperfect buys. My first buy is set at $9, with more at $8 and $7. I've been talking to clients about this for weeks now and have been able to line up some money. I suspect others have been too, so I expect a relativly quick recovery to some level of strong support.

Sep 02 11:40 AM

[Barbarous R...:]

What people don't seem to get is that by buying and holding UNG, you are effectively already buying gas further out the curve -- YOU ARE NOT BUYING SPOT!

The gas recovery is effectively already baked into the NAV of UNG through the impact of future contract rollovers. Oh, and you're paying an additional 16% premium for this "opportunity".

Buy gas-related stocks instead. And if you're risk averse (as I am), short gas commodity ETFs on the other side as a hedge. You'll likely make money on both sides of the trade.

Sep 02 12:15 PM

[i'mwithher:]

good point, barbarous

Sep 02 12:23 PM

[reluctantQuant:]

I'm sure it's different this time.
<grin>
--rq

Sep 02 02:37 PM

[Windsun33:]

Every time I think this can't go any lower, it does.

Not into it much, only about 1% of my total portfolio, so I can afford to hold onto it forever - and at my current 25% loss on it, not much point in selling it.

If it is still down at the end of Dec, it will make a good tax reduction for my capital gains... (gotta be some good news here someplace).

Sep 02 03:02 PM

[mind_geek:]

True...however they've been saying sell since the 50% drop in prices. At this point, wait for some sort of crisis to happen to the oil market (real or perceived by the media) that starts the whole 'gas as an alternative' talk again or wait for "Natural Gas...will it go to zero?' magazine covers to hit the stands...they are always wrong. I'll be the first one buying in that case!

The whole gas/crude historical ratios investment thesis no longer works..people got suckered on that one, including me.


On Sep 02 09:18 AM Stockgobblin wrote:

> When everybody and their mom is saying sell, I do the opposite.

Sep 02 06:03 PM

[zaparozhe:]

This is a terrible vehichle to use to be long NG. Between the current contango and the premium over NAV the only thing growing between now and December is your tax loss. Your only hope is to pray for another Katrina between now and then.

If you feel you need to own NG look for some of the gas producers with real assets not a gimmick ETF sold by the street.


On Sep 02 03:02 PM Windsun33 wrote:

> Every time I think this can't go any lower, it does.
>
> Not into it much, only about 1% of my total portfolio, so I can afford
> to hold onto it forever - and at my current 25% loss on it, not much
> point in selling it.
>
> If it is still down at the end of Dec, it will make a good tax reduction
> for my capital gains... (gotta be some good news here someplace).

Sep 02 06:35 PM

[SCN4:]

Could somebody PLEASE tell me if they know how to find the roll dates and daily holdings of GAZ? UNG is a great trading vehicle if you understand what contango and the published protocol, but it is now difficult to sell short. GAZ seems like a possible alternative, but I cannot find roll dates ANYWHERE! Please help me out if you know where this can be found. And yes, I have looked in the prospectus and could not find it there.

Sep 02 09:37 PM

[Maxe Paul:]

Sophisticated investors would not touch a garbage ETF such as this, you can trade NG for as little as $1.00 a contract, i just dont understand what people see in these extra ways (UNG) to lose their money.

Sep 02 10:55 PM

[Windsun33:]

Considering that I got it long ago, when it was only around 2% over NAV, not a big deal. Only out around $400, and now I am stuck in fascination mode with watching it just to see how low it can go.


On Sep 02 06:35 PM zaparozhe wrote:

> This is a terrible vehichle to use to be long NG. Between the current
> contango and the premium over NAV the only thing growing between
> now and December is your tax loss.

Sep 02 10:56 PM

[Windsun33:]

GAZ is not much better - it is trading at a 9% premium last report I saw. I also have some FCG that I got at around $9 last March, but those are at least real companies.


On Sep 02 09:37 PM SCN4 wrote:

> Could somebody PLEASE tell me if they know how to find the roll dates
> and daily holdings of GAZ?

Sep 02 11:13 PM

[User 478884:]

Its a good idea to sell forward Jan contracts on NYMEX and to buy UNG - though not all at once, I would suggest buying UNG starting at $9 and averaging about 10% of the intended portfolio every week. One can get a good premium for the Jan sale contract, so the two way contract is surely profitable in January at the point of expiry at todays prices (Sept 3).

Sep 03 03:56 AM

[Not Jerry A...:]

when the priemum goes back to zero it will be time to add...only way it's going to get there is when people who are holding the name realize that the 20% premium is killing them...yesterday it closed at 12%....today is currently around 15%...when it gets to zero or very near i'll be buying...lets call it a guestimate of around 6-8$'s a share...

to the post above i'd do the opposite...sell ung calls buy the futures - if you feel you have to get nat gas right now...best bet is to hold off, buy puts on ung or write calls on ung...the premium makes it impossible to make money on this name...when the time is right long term at the money calls, sit back and relax...

Sep 03 11:27 AM

[farwest:]

For those suggesting to not buy the ETF and instead buy the producers, beware that the street has long ago bid up almost all the producers and value them as if NG was $6 again. There is no point in buying now.

From my ciphering, I can't find value anywhere for NG producers, certainly not in the CHKs of the world. Bank lines will be pulled soon as credit redeterminations kick in. Year end SEC reserve updates will decimate reserves with <$4 mcf, causing even more credit lines to be pulled. Pity the play who is unhedged or has significant hedges rolling off (likely at $8-$9 being replaced with $5-$6).

It appears way too many people think this is just another usual nat gas market - it isn't - the massive discoveries in shale coupled with technical advances with fraccing has turned the industry on its head and low prices (~$5mcf) are going to be around for years. All I can say for NG bulls, you better be praying for an unusually cold winter - else you'll enter next year with a huge over hang again.

Sep 03 09:41 PM

[zaparozhe:]

People, forget about the premium problem for the moment. UNG is a wasting asset with existing contango. unless there is a quick spike from a hurricane the nav will just be eaten away (quickly) over the next six months. If you don't understand how this works you should just stay away or toss greenbacks out your window as you drive down the highway.

FYI, last day for trading NG k's is 9/28. So the fund needs to roll by then.

Sep 04 12:32 PM

[rick12345:]

Call me naive, but if natural gas becomes cheap enough why wouldn't demand and therefore its price subesquently rise ? It's like summizing that the price of oil is about to fall to zero because more people are moving toward fuel efficient vehicles. Natural gas is a clean fuel that has far more potential than other non-renewable resources like coal and oil. I know that I for one would rather pay $1 a gallon for compressed gas (probably less once tthe technology is refined) than $3 a gallon for petroleum.

Sep 05 09:55 PM

[zaparozhe:]

you are correct. when price is less than cost of production supply will slow down, eventually. Low price will also increase demand for NG - things like LNG for vehichles have great future. Key is "EVENTUALLY". UNG rolls the front NG contract which will not help you. The futures market reflect higher gas prices (more than 2x) down the road.


On Sep 05 09:55 PM rick12345 wrote:

> Call me naive, but if natural gas becomes cheap enough why wouldn't
> demand and therefore its price subesquently rise ? It's like summizing
> that the price of oil is about to fall to zero because more people
> are moving toward fuel efficient vehicles. Natural gas is a clean
> fuel that has far more potential than other non-renewable resources
> like coal and oil. I know that I for one would rather pay $1 a gallon
> for compressed gas (probably less once tthe technology is refined)
> than $3 a gallon for petroleum.

Sep 08 12:25 PM

[francis C:]

I just read all the comment on this blog and I find it interesting. I have been on the hunt of financial news about NG since mid winter 2009 for investments opportunities. It seems the most important key has been forgotten on this forum! Every one seems to agree about what is needed for the recovery of NG futures; the storage figure, storage capacity, the demand (short and long term), the recovery of the economy, the NG electricity production and the weather. Investors are either: 1) BULL or Bear in the ETF market (making ridicules money in the downturn @ Bear position ex. HND. “when” to transfer your position to Bull ex. HNU. 2) NG Producers that are important players, who can survive this crises.

Speculation! Speculation in the market is what will trigger all factors to the start the recovery of the NG price. Right now it is on the down waiting to burst for an other rally up.

Sep 08 01:34 PM

[Mad Hedge F...:]

utuo. Just when I get comfortable with my view on Natural Gas, I get a scratchy, reverberating cell phone call from one of the major formations telling me that I’m being way too bullish. Gas won’t bottom at $2. The free fall will continue until it hits $1. National storage will be completely full imminently top out, and when it does, the producers will have to shut down completely. Since these guys are leveraged up the wazoo, this will trigger a string of bankruptcies, and the majors will fall like dominoes. A hedge fund bust won’t define this bottom, as these guys are all playing from the short side. UNG can’t step in as a buyer of last resort, as the SEC won’t let it issue more stock, and the current shares are trading at a ridiculous 20% premium. One thing we do agree on is that the bottom will look ugly, whatever the spark is. You often get Armageddon type views near market bottoms, but this guy has been dead on right until now. Well, it takes two to make a market. Conclusion: keep NG nailed to your screen, as the widow maker is where the volatility lives.

Sep 09 01:18 PM