By Sumit Roy
Two new products aim to make betting on contango easier than ever.
In an odd case of product following controversy, two new ETNs designed to make playing the same calendar spread used by Arcadia traders in their alleged market manipulation are now available in a convenient exchange-traded note.
Natural gas has been out of the headlines for a while now. The fuel attracted intense attention during late 2009 and through 2010, as investors scrambled to catch the bottom in the plunging commodity. That bottom came in September 2009, yet the vehicle that many investors chose to invest in natural gas with — the United States Natural Gas Fund (UNG) — kept on sinking.
Indeed, UNG has fallen consistently since then, most recently hitting a new all-time low in March of this year. The reason for much of UNG's poor performance isn't entirely unrelated to the actual decline in natural gas prices, but contango is what really explains UNG's massive underperformance against spot natural gas.
This phenomenon should be well understood by investors by now. But the knowledge has come with a steep price tag for the many who likely had to learn from experience. Since the beginning of 2009, spot natural gas prices have fallen 18 percent, while UNG has plummeted 78 percent.
Year-to-date in 2011, the differential is still quite stark, with spot prices down 2 percent and UNG down 12 percent; the fact remains that persistent contango in the natural gas market continues to take a bite out of returns in funds such as UNG.
We observed a similar phenomenon in crude oil, as the United States Oil Fund (USO) has strongly underperformed the spot West Texas Intermediate prices that it attempts to track, though not nearly to the extent observed in the UNG-natural gas situation.
Given these ugly return figures, it's unsurprising that many ETF providers have attempted to create new products to ameliorate the impact of contango. The United States 12 Month Natural Gas Fund (UNL), for example, holds a basket of natural gas contracts along the futures curve, not just the front month.
This strategy has helped to some extent; year-to-date UNL is down 9 percent, less than UNG's 12 percent. In UNL's case, while contango is minimized, it isn't eliminated.
The newest innovation in this space was introduced today — via the E-TRACS GASZ ETN and E-TRACS OILZ ETN. The former will be linked to the performance of the ISE Natural Gas Futures Spread Index, while the latter will be linked to the ISE Oil Futures Spread Index.
These indices actually attempt to profit from contango at the front end of the natural gas futures curve. The ISE Natural Gas Futures Spread Index essentially puts on a calendar spread in which it shorts the front month, while going long the twelfth, thirteenth and fourteenth month contracts, and maintaining 1-to-1 long/short exposure.
Given the shape of the futures curve, this strategy has performed remarkably well, outperforming not only UNG and UNL, but spot natural gas prices themselves. Since the beginning of 2010, spot natural gas prices are down 27 percent; UNL is down 42 percent; UNG is down 48 percent; but the ISE index is actually up 6 percent.
But given such significant outperformance versus spot natural gas prices, does this index provide the exposure that investors are looking for? For investors seeking long exposure to spot or front-month natural gas prices, the answer is obviously no. Since the index's inception, its correlation with spot natural gas prices has hovered near -0.90 — unsurprising considering the short exposure to front-month natural gas contracts.
That's in contrast to UNG, which has a 0.90 correlation with spot prices. In the end, the ISE Natural Gas Futures Spread Index is just that — an index that provides exposure to a calendar spread position. That is what investors in E-TRACS' GASZ can expect. If total returns — including roll costs — on natural gas futures further out on the curve exceed those of the front month, GASZ should perform well. But that's a play on the shape of the forward curve, not a directional bet on natural gas prices.
The other similar product E-TRACS is launching focused on crude oil — OILZ — will work similarly, except that it will seek 1.5-to-1 long/short exposure using a similar strategy of shorting front-month oil futures contracts, while going long midterm oil futures contracts — not dissimilar to the same spreads played by the accused in the Arcadia allegations.
Since the beginning of 2010, the index that OILZ will track — the ISE Oil Futures Spread Index — has returned 7 percent, which compares to the 14 percent spot return and the United States Oil Fund's -9 percent return.
While these funds represent interesting hedging tools for investors (perhaps in conjunction with long exposure to the underlying commodities) it's worth noting that these are really only tangentially related to the actual premise of long commodities investors. Still, sharper tools are always welcome.