Natural Gas Fund Is Flaming Out

Aug.22.08 | About: The United (UNG)

I seem to have a real knack for investing in funds that don't quite work as one would expect. For instance, there was that little incident back in February with the UltraShort FTSE/Xinhua China 25 Fund. Since then I have moved on to investing in natural gas, as I have indicated in the past that I thought natural gas was underpriced relative to oil. The vehicle that I chose for doing this was the United States Natural Gas Fund (NYSEARCA:UNG).

Now, aside from the fact that natural gas prices have fallen since I made my investment and the fact that they have fallen faster than oil prices, I have recently determined that this fund is performing even worse than the underlying commodity - by a huge amount. Check out these numbers:

  8/1/07   8/13/08  Change
UNG  40.56 39.68 -2.2%
Natural Gas Spot Price  6.19 8.11 +31.0%
Tracking Error     33.2%
Click to enlarge

What's going on? Clearly this fund is not exactly working as one would expect or hope. However, technically it's working exactly as advertised. How can that be? Well, people buy these types of funds because they hope to take a position in a commodity, and when they think about the price of a commodity they are typically thinking of the spot price. In fact, the UNG prospectus even says "The investment objective of USNG is to have the changes in percentage terms of its units’ net asset value (‘‘NAV’’) reflect the changes in percentage terms of the spot price of natural gas delivered at the Henry Hub, Louisiana".

So there you have it - except there's more to this sentence. It goes on to say, "as measured by the changes in the price of the futures contract on natural gas". You see, unfortunately, there is really no practical way for a fund to invest in a commodity at the spot price unless it is able to actually buy and sell the physical commodity and store it in between. In the case of natural gas that would be really difficult. Therefore, these funds invest in the next best thing, which is the front month futures contract for the commodity, and as those contracts approach settlement they roll them over to the next month's contract.

The prospectus goes on to say that "The General Partner believes changes in the price of the Benchmark Futures Contract historically exhibited a close correlation with the changes in the spot price of natural gas." The only problem is that the prospectus also goes on to point out ad nauseum that one of the risks in investing in this fund is that the futures contracts may not correlate well with the spot prices. In other words, as the data above clearly proves, you shouldn't bank on the general partners's belief.

As an interesting side note, all the performance measurements of the fund are relative to the front month futures contract, not the spot price - and you really couldn't expect them to measure themself any other way. Of course, according to these measures they are doing a fine job.

Unfortunately, this discrepancy between futures prices and spot prices is not new to me as I noted my disappointment in the performance of a sister fund for oil, USO, back in January. The exact same phenomenon (contango) is at play here with natural gas, except in a much bigger way! During this time period the futures market was predicting that natural gas prices were going to rise. Therefore, the front month futures contract tended to be higher than the spot price. Since the fund is always buying the front month contract at a premium to the spot price, it really won't profit unless the spot price ultimately exceeds the futures price paid.

In other words, if spot prices at settlement always matched the original contract prices paid then the fund would have no profits whatsoever. You could be right about gas prices rising and still have no gains to show for it. Worse yet, if spot prices fall short of the futures prices then the fund will lose money.

Of course, futures markets periodically move into backwardation, where the futures prices are lower than the spot prices. And natural gas regularly moves in and out of backwardation (and contango) because of the seasonality of demand. However, even in backwardation the rules for profiting are the same - spot prices have to end higher than the future price paid in order for the fund to gain.

So what can you really expect from a fund like this? I think it's complicated. In theory the futures markets are the best predictors of future prices for commodities. On average their predictions should be high just as often as they are low and the two effects should cancel within these funds. Therefore, there's an argument to be made that you can't really benefit in these funds from previously anticipated increases in commodity prices. On the other hand, you should be able to benefit from the impact of new information that would affect the front month contract, and presumably the spot prices as well.

Stock position: Long.