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Sometimes, the market gets so speculative that strange things happen. This is one of those times.

The iPath Dow Jones UBS Natural Gas (NYSEARCA:GAZ) is an ETN (Exchange Traded Note) that tracks the Dow Jones-UBS Natural Gas Total Return Sub-Index. In short, it tries to replicate the price behavior of natural gas. And for most of its past, it did so rather closely.

However, back in 2009 the creation of units for this ETN was suspended. ETNs, like ETFs, get a low tracking error through the mechanism where authorized participants can create or redeem units. This mechanism establishes an arbitrage between the ETN/ETF NAV (Net Asset Value), and the price it trades at in the market. If the price gets too high versus the NAV, the authorized participants can usually create more units of the ETN/ETF by delivering the underlying to the fund and then they sell these units in the market, bringing the price down towards the NAV. Conversely, if the price gets well below the fund's NAV, the authorized participants will buy and redeem units - getting the underlying assets - and then liquidate those assets. This buying of units will pressure the price upwards towards the NAV.

But since the creation of units for GAZ was suspended, once demand for that particular fund started pushing its price well over the NAV there was little the market participants could do to bring it back in line. There was shorting of the ETN, but then it became hard to borrow and there was nothing else that could bring it back. So what happened? The fund really detached from its NAV, indicating huge uninformed speculative demand. The chart below, using United States Natural Gas Fund (NYSEARCA:UNG) as a proxy for natural gas prices, shows this event.

click to enlarge

The overvaluation of GAZ hit as much as 90%, meaning the ETN traded as much as 90% over its NAV. For anyone buying the fund at those levels, it would mean that for each $1 in GAZ he was buying, he'd be getting less than 53 cents in natural gas - an incredibly expensive preposition.

Even today GAZ trades at $4.32, but its NAV - which you can check yourself at Yahoo Finance by looking up the quote to ^GAZ-IV - is just $3.03. So GAZ, in spite of converging in the last few sessions, is still trading at a premium of 42.6%, and would have to fall 29.9% to get back in line with its NAV.


There are two conclusions to draw from this event. One is that if you have GAZ, you really have to sell it as fast as you can. Maybe replace it with UNG if you want to keep exposure to natural gas, though UNG has its issues as well.

The other is that this event is a sign of unbridled, uncontrolled, uninformed, speculative demand for commodities, to a point where it doesn't take into account the most basic of fundamentals - and I am not talking about physical production or supply here, I am talking the kind of speculative demand that doesn't even care about paying $1 for $0.50. This is a huge warning sign regarding the speculative nature of the market at this point, at least for the commodities (NYSEARCA:GSG) sector.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.