Why UNL Is A Better Alternative To UNG For Natural Gas Exposure

Includes: UNG, UNL
by: Harry_Briggs

By now there is considerable awareness of some of the shortcomings associated with using the United States Natural Gas ETF (NYSEARCA:UNG) as a vehicle to gain exposure to natural gas prices. UNG relies solely on prompt month natural gas futures contracts to gain exposure to natural gas prices, and its transparent methodology for rolling futures contracts from one month to the next is exploited by natural gas traders. This has caused UNG to fall harder than natural gas prices generally have.

However, there is a misconception about the degree to which UNG has underperformed natural gas prices. When people look at a chart of UNG, they may compare it to a chart of prompt month natural gas prices, and see a significant lag. A continuation chart of prompt month natural gas futures contracts creates the impression you are viewing price changes of one security across time, but in fact you are viewing prices changes of multiple securities across time. This is demonstrated in the two charts below, showing UNG and natural gas prices in 2011.

Click to enlarge:

The first chart tempts you to compare the yearly change in prompt month natural gas settlements with the yearly change in UNG. The difference between the 12/31/2010 settlement of the February-2010 contract (4.405) and the 12/31/2011 settlement of the February-2012 contract (2.989) is minus 32% (versus the 46% decline UNG experienced over the same period), but clearly calculating a change across contracts is meaningless. The second chart doesn't tempt you into making such a miscalculation because of the obvious discontinuity of the discrete lines for each contract. The only appropriate comparison for UNG is the cumulative daily return for each contract, which is currently prompt. This assumes (not unrealistically) that we can roll the value of each expiring contract into the new prompt contract, exactly at expiration, at relatively little cost. I performed this calculation, and it is shown below.

Click to enlarge:

UNG underperforms the cumulative return of prompt natural gas contracts by only 4%, and part of this is the approximately 1% fee charged by UNG. Losing 46% in a year is not fun, but UNG's return is reasonably close to an appropriate benchmark. In fact, before performing the calculation, I thought the slippage would be much greater than 3%.

For the sake of having another benchmark, the February-2012 contract was 5.215 on December 31, 2010. On the final trading day of 2011, this contract settled at 2.989, or a 43% loss, which is actually slightly worse than the loss incurred by rolling holding prompt futures contracts and rolling them on expiration.

A better alternative for getting exposure to natural gas prices is the United States 12 Month Natural Gas ETF (NYSEARCA:UNL). UNL is similar to UNG, except that its future positions are distributed relatively evenly across 12 months instead of just one month. Its performance has been better than UNG, and its performance is in line with an appropriate benchmark, once its expense charge is considered (-40% versus -39% respectively). I would recommend UNL over UNG to any investor looking for direct exposure to natural gas prices.

Click to enlarge:

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