Can UNL Tackle the Natural Gas Contango That's Plagued UNG?

Nov.19.09 | About: The United (UNG)

By Lara Crigger

Can USCF's new fund tackle the natural gas contango?

United States Commodity Funds' new ETF, the U.S. 12-Month Natural Gas Fund (NYSEArca: UNL), began trading yesterday, offering investors another easy access point to the natural gas market. But let's hope it sees smoother sailing than its controversial cousin, the U.S. Natural Gas Fund (NYSEArca: UNG).

Not only have regulators vociferously blamed UNG for distorting the commodity markets earlier this year, the fund has also performed dismally to date, dropping a whopping 61.24 percent since the beginning of the year. And it's not because investors have lost their taste for the fund: Last month, UNG still saw brisk inflows of $308 million, even as its net assets dropped $263 million.

Record-low natural gas prices have played their part in slashing UNG's returns, of course, but the big anvil weighing the fund down is the market's nasty case of contango. For the better part of the year, the front-month NYMEX natural gas futures contract has stayed cheaper than those with later delivery dates. And since UNG buys only the front-month contract, selling it near its expiration date to purchase the next-nearest month's contract, the fund has been stuck in a wicked cycle of "sell low, buy high" for months now.

UNL, on the other hand, may be able to avoid some (but not all) of the same pricing sting. Instead of focusing solely on the front-month contract, UNL purchases an equally weighted basket of futures contracts with delivery dates in each of the next 12 months. Two weeks from rollover time, the fund sells the front-month contract and buys the one 12 months out, essentially pushing the basket forward in time.

Given that currently UNG must absorb losses across 100 percent of its contracts during rollover, while UNL only experiences losses in 1/12th of its portfolio, this methodology should protect the latter somewhat from contango's vicious sting. But it can't make UNL entirely immune, considering the furthest-out contracts are still priced substantially above the front-month contract: Yesterday, the December 2009 contract closed at $4.254, while the December 2010 contract closed 45.7 percent higher, at $6.199.

Also consider that at 0.75 percent, UNL's expense ratio is a mite bigger than UNG's (0.60 percent), so when the contango lessens, any cost savings from choosing the former over the latter would naturally erode. And should the natural gas market flip to backwardation, UNL's staggered buying strategy would actually put it at a disadvantage to UNG.

But backwardation's not likely to happen in natural gas—at least, not anytime soon. To see inversion occur, we'd need to start seeing shortages in the physical commodity, yet natural gas stocks just hit an all-time high. In fact, the International Energy Agency recently predicted that even if demand rebounds, due to an extra-cold winter and economic recovery, we'll still see a natural gas surplus that will depress prices until 2015.

Will UNL ultimately outperform UNG until then? Obviously only time will tell, but we may be able to divine some clues from USCF's other 12-Month Oil Fund (NYSEArca: USL) and its UNG-analogous partner, the U.S. Oil Fund (NYSEArca: USO). Despite oil's price recovery, the commodity has also experienced heavy contango recently, and year-to-date, USL is up 38.84 percent, while USO is only up 22.87 percent.

Still, while I'm always happy to have more tools in the box, when it comes to natural gas, I'm not yet sure whether a flathead or a Phillips screwdriver would be better.

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