Natural Gas Fund Is Flaming Out

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 (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%

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.

Comments

[Rocknbob:]

Im in the same boat as you, Gary. After poring over the prospectus for UNG, I invested anyway because I wanted a position in NG. The tracking of the commodity itself, as you duly noted, has been horrible. I hope the contango and backwardation do balance over time, however, and I really only see upward pressure on prices , especially going into the winter.

2008 Aug 22 09:57 AM

[DougM:]

Why not try the futures market? You could buy a gas contract for years out into the future for 10% down, then park the rest of the collateral in treasuries. Minimal transaction costs, and (versus the target year) no tracking error.

2008 Aug 22 11:34 AM

[huangjin:]

George : It's not working, Jerry. It's just not working.

Jerry : What is it that isn't working?

George : Why did it all turn out like this for me? I had so much promise. I was personable, I was bright. Oh, maybe not academically speaking, but ... I was perceptive. I always know when someone's uncomfortable at a party. It became very clear to me sitting out there today, that every decision I've ever made, in my entire life, has been wrong. My life is the opposite of everything I want it to be. Every instinct I have, in every of life, be it something to wear, something to eat ... It's all been wrong.

( A waitress comes up to G )

Waitress : Tuna on toast, coleslaw, cup of coffee.

George : Yeah. No, no, no, wait a minute, I always have tuna on toast. Nothing's ever worked out for me with tuna on toast. I want the complete opposite of on toast. Chicken salad, on rye, untoasted ... and a cup of tea.

Elaine : Well, there's no telling what can happen from this.

Jerry : You know chicken salad is not the opposite of tuna, salmon is the opposite of tuna, 'cos salmon swim against the current, and the tuna swim with it.

George : Good for the tuna.

( A blonde looks at George )

Elaine : Ah, George, you know, that woman just looked at you.

George : So what? What am I supposed to do?

Elaine : Go talk to her.

George : Elaine, bald men, with no jobs, and no money, who live with their parents, don't approach strange women.

Jerry : Well here's your chance to try the opposite. Instead of tuna salad and being intimidated by women, chicken salad and going right up to them.

George : Yeah, I should do the opposite, I should.

Jerry : If every instinct you have is wrong, then the opposite would have to be right.

2008 Aug 22 05:24 PM

[sbenard:]

I have been waiting a long time to buy this fund. It looked like it had bottomed and would start to climb after yesterday. However, the price of Nat Gas cratered today. Last year nat gas bottomed at about $7.50, just about 50 cents lower than where we are now. Nat gas tends to rise in the fall/winter months. Liquidity for this fund is excellent. What's not to love? The technical charts for the futures and the ETF are virtually identical, too!

2008 Aug 22 09:02 PM

[Gary Lucido:]

huangjin: Interesting that you would quote this episode of Seinfeld. I often use it to explain why I invest in individual stocks...the reason being that if I was consistently bad at it then I could just start doing the opposite of all my trades.

sbenard: My whole point is that you can't possibly benefit from the normal seasonal increase in prices because that's already reflected in the futures market. The fund will be always buying at the higher prices, not the lower spot prices. Also, I don't buy the technical mumbo jumbo. No offense.

2008 Aug 22 10:34 PM

[john s. gordon:]

oil from colorado shale - the industry had viable processes & was ready to go in 1927 & then east texas came in big time. there has been no process development on shale oil since that time. the resource is a good source of aliphatics (jet-A, kerosene, diesel etc.). there was an effort to start something with the NOSR (naval oil shale reserve) in 1980 but that was killed by r.reagan.
> jack

2008 Aug 23 09:16 AM

[erniem:]

A. The energy costs today are not the reason for foreclosure. Foreclosures are due to ARMs resetting and people buying houses they could hardly afford with zero down and cash back.... And the predators who willingly sold them the loan.

If our average energy costs double, it is still a small part of our budget.

UNG is a fund for speculators. If you want to buy NG, buy CHK, DVN, WLL or other companies. If you want to SPECULATE buy UNG and complain when your speculation was wrong.

2008 Aug 23 11:42 AM

[Steven Ward:]

NG is a tough market to invest in due to a lack of worldwide pricing versus oil. I see this fund as only a trading vehicle and not a stock type investment for even a short term. The problem is that the management of the fund may have not touted the fund as an invest and hold entity but it sure sets it up as one where all the pricing profits and losses are comming from a volatile commodity based on a futures price that supposedly will match a spot price where both entities violently flucuate.

The structure of the fund does not offer any leverage in the true sense of the word for the upside and only offers declines if its major thesis doesn't work out which it isn't.

Investors are better off directly investing in the futures contract itself if they want volatility or if they seek an investment like an equity stake to purchase some of the larger Australian Oil and Gas stocks where LNG train building is going on and where Korea and Japan are paying the highest NG prices in the world. And will continue to do so for the next 3 years.

2008 Aug 23 12:28 PM

[Paul Killinger:]

Gary,

You were better off in China.

2008 Aug 23 12:31 PM

[Paul Killinger:]

Peter,

Everything you say is exactly correct.

This is small comfort, however, when we stop by our local gas station.

Have patience, my friend, the voters (except maybe in CA) have figured this out.

2008 Aug 23 12:34 PM

[searcher:]

Thank you Ernie and Steve. Preserve us from pointless rondos of all too familiar carping.

2008 Aug 23 12:59 PM

[Amateur Eco...:]

You are making some very broad statements based on a very limited analysis. If you do the same comparison of change in spot price vs change in UNG price for the 1/1/08 to 7/3/08 and 7/3/08 to 8/13/08 time periods you will find that the UNG and spot price changes are very correlated.

2008 Aug 23 02:06 PM

[fran:]

if you're going to play in the futures market, you'd best understand the rules before entry. and you'd best follow the subject with care and dilgence, just as any investment.

noone removed caveat emptor labeling advice to my knowledge.

don't you heed Cramer? homework stupid!

2008 Aug 23 02:13 PM

[Gary Lucido:]

Amateur economist: Of course you are correct. I noticed that but my point is that it can be way off over some very long time periods. It's clearly very susceptible to contango and backwardation and those may or may not cancel in any given time frame.

Fran: I completely understood the rules before entry but was surprised at the magnitude of the impact of contango. As for Cramer...no I put no faith in that guy. The guy is a clown.

2008 Aug 23 02:16 PM

[Amateur Eco...:]

I guess the best thing to do is buy low and sell high.

2008 Aug 23 02:48 PM

[Greg Pinelli:]

Will have to disagree with you about UNG..it's an excellent vehicle for taking advantage of abnormally low natgas prices and riding the corrections upward..Trough to peak..and peak to trough...here are the comps..
UNG +82% UNG -41%
NatGas +92.86% NatGas -40.74%

Bottom line..you give upsomething on the upside..small change on the downside..Convenience and liquidity..excellent.

2008 Aug 23 03:03 PM

[phillips49:]

I recently read in Platts that natural gas producers look at $8.00/mmbtu as a breakeven point to begin to moderate production and drilling. Now may be a good entry point for natural gas producer stocks. You may not see much gain until late spring 09 though when the storage process begins again. EIA reports current storage is 9% lower than a year ago this time, but still in the middle of the 5 year average range. No shortage now. No excess either. If a huuricane disrupts production in the Gulf, prices will shot up. If winter is colder than normal and depletion is higher, prices will shoot up quickly. If producers cut back production the price will go up. $8.00/mmbtu appears to be a good lower support level.

2008 Aug 23 05:03 PM

[NOWHEREMAN:]

Very good posts, both pro and con.
This is my kind of Q&A, I don't have to shoot down either side with either Best or Worst case scenarios.

Thank you for the Info.

2008 Aug 23 05:18 PM

[billp37:]

Conventional natural gas production in the US apparently peaked in 2001 according to EIA.

Now we are reading about nonconventional natural gas filling the void.

Some plots can be found of nonconventional natural gas here:

www.prosefights.org/pn...

Oh dear!

"Aug 17, 2008 CHEYENNE, Wyo. (AP) - The state has canceled or suspended permits on 243 natural gas wells in Wyoming.

The well have not produced gas for years but have continued to discharge millions of gallons of water as a byproduct.

And the state is targeting nearly 1,000 additional such wells.

The wells were drilled in the Powder River Basin in search of coal-bed methane. Because the gas is often trapped by water in surrounding aquifers, companies must pump out the water to relieve pressure on the seams and release the gas."

www.prosefights.org/ga...

Cheers
www.theoildrum.com/nod...

2008 Aug 23 06:18 PM

[jjason:]

You should have stayed the hell out of NG speculation.

2008 Aug 24 07:24 AM

[billp37:]

Are you referring to amaranth?

en.wikipedia.org/wiki/...

2008 Aug 24 10:19 PM

[Kunst:]

jjason, what are we going to do with you?

2008 Aug 27 01:44 AM