H. T. Love's  Instablog

I have very little to say here as a picture is worth a thousand words.

If you have followed my posts and comments, or those of many more knowledgeable Seeking Alpha participants, you are by now aware that UNG has changed the way it attempts to accomplish its goal to avoid possible CFTC limits. You are also aware of the issue of negative roll yield during periods of contango.

These issues have been described, but the words you have read may not have had as dramatic an impact as the below image.

The below partial "snapshot" of this UNG Daily Holdings web page, on Wednesday 10/14 at 21:16 EDT, tells the whole story. Note that it changes daily, so the contents may vary depending on when you visit the page.


(Click to enlarge)



Due the math and note the reduced number of positions after completion of the next three roll periods (hint: -7,955?). On a part of the page above that is not shown in the "snapshot", the total holdings after the first roll day was completed are 180,960 positions. If price ratios remain unchanged over the next three rolls, the net positions will decline a further 4.4%.

To add insult to injury, the November futures contracts (the current UNG position being exited) has begun the expected price decline and the December contracts (the position being entered) are also declining now, albeit more slowly than the November contracts. If the futures contract prices continue to decline, UNG will again own fewer contracts which are declining in value at the end of the roll period.

While writing this article, I checked the previous session contracts. November showed a -$0.152 decline to 4.436 and December showed a decline of -$0.118 to $$5.357.

Prior to the start of roll, the NG:UNG price ratio was 2.39:1. After roll is completed, if nothing else changes, we can expect 2.285:1.

Note that this is also options expiration week and that can have an effect on UNG prices if short covering is in play.

Go to the Nymex Natural Gas current session contracts to see current prices. You can also select the previous session to see what prices were at close of the previous session. Click on one of the contracts to bring up a chart, which can be used to show various intervals.

Premium paid at end of 10/14 was +3.77% (NAV $10.60, market closing price $11.00).

The new prospectus is available from the UNG website in PDF format under the Literature drop-down menu.

Disclosure: long UNG, short covered calls, long synthetic short positions.

A CURIOSITY: Over the period from Friday September 4 through Thursday September 10, the price of UNG units in the market ran up from the close on September 3 of $9.01 to a close on the 10th (the Thursday of the weekly EIA NG reports) of $11.18, a 24.08% increase.

This was accompanied by a puzzling run-up in NG prices. (Click chart to enlarge)


The reason I say "puzzling" is that the weekly EIA summary report for the previous week, issued 9/3, indicated gas in storage still 18% above 5 year averages and reported a net injection of 65 Bcf, slightly higher than the 5 year average of 64 Bcf but below last year's 92 Bcf by 29%. The way net injections have trended over the last five or six weeks, I think there is absolutely nothing unexpected or unusual about this net injection. Storage was 17.8% above the 5 year average, a slight drop from the highs in the previous weeks. Still, nothing to cause one to turn hand-springs over.

In the EIA NG Weekly Update, this weeks injection of 69 Bcf was slightly higher than the 5 year average of 67 Bcf and last years injection of 63 Bcf. This leaves storage at 17.1% over last year and 17.4% over the five year average. This is a mild improvement over previous weeks "overstock", but should have been expected since rigs were dropping like flies until 6 or 7 weeks ago. In spite of this, NG finished higher Thursday.

I heard a lot of chatter on CNBC saying the traders said short covering caused the price rise. Maybe this explains it. Maybe not. We'll consider this more a little later.

A new gas in storage record is expected at the end of injection season - 3,842 Bcf. Winter weather is predicted milder than normal, hurricane season has been a real dud, Baker-Hughes rig counts increased 7 weeks straight, demand is an anachronism that used to describe what justified producing a product, EIA expects October prices to average $2.25, everybody is expecting a big ramp-up in LNG imports, and the latest EIA-reported consumption (May and June) is in line with previous year's norms.

Nevertheless, CNBC reported the traders viewed this injection as "less than expected". ???!

Is it possible the traders figured all the new rigs over the last 7 weeks - now back up to 699 (2003 levels and the previous week it was 701) from 665 on 7/17, +5% - got new wells operational, hooked up to pipelines and pressurizing already? Did they expect a veritable tsunami of new injections would occur? Does this explain the view that it was "less than expected".

I'm sure the traders have at least as much information as I. And they certainly have much more experience. Combine the two and you know they are not going to be too far off the estimates of net injections. If this injection is within what I would expect (and it was), give or take a couple percent, you know they had it nailed.

I really would like to know what caused this price behavior and why the latest injection was "less than expected". As part of my steep learning curve I'm not afraid to ask questions and look ignorant. I just don't want to remain ignorant.

Anyone care to fill me in? I certainly would appreciate it.

Until I learn more, I don't believe I heard the truth.

What about the "short covering"?

The September contract closed August 27 and the October contract closes September 28. If you were short, would you be covering during a 25%-30% price increase knowing all the above? Would you be causing it? With two full weeks left until trading termination and being aware of all the above would you feel pressured (or fearful) enough to cover now as prices ran up 25%-30%?

So, either there is something I have overlooked, certainly possible and even likely, something that I'm still really ignorant about (lots of those things, still) or there is something else going on.

Could options on NG derivatives cause this? I don't know enough about how those work to say. But even those options can trade through September 17. If everybody who was long a put closed out their positions to take profit, could such a run up be caused? What if they exercised them? Would this cause such price behavior? Certainly folks know that NG is heading down and would wait for better profit on those puts, wouldn't they? Like I said, I'm just too ignorant of this stuff to know.

What about long calls? Could a massive exercise of those cause it? This seems a distinct possibility. But if the holders knew the above, why would they hold calls now? Is it possible that some call writers were naked, got assigned and had to cover? Again, "I plead the fifth" since I'm ignorant of the mechanics of these things.

Any help on the mechanics of this would be helpful and appreciated.

Today, September 11, NG reversed course, getting as low as $2.77, if I recall. Last settle at 17:15 on the October contract was $2.96 and last trade was $2.98, -$0.296. I feel much better now. It's at least moving as I would expect, given my minimal knowledge and experience. If it didn't do this at some point, I would have to toss all I had worked so hard to learn as being erroneous. There's still so much to learn, but I at least felt I had begun to acquire a foundation.

Anyway, on with the story. Lets take a quick look at the UNG 200 day chart and note the nice, calm, as-expected downward trend over the last few weeks or so. Then notice what may have terrorized shorts in UNG the last three or four days. (Click to enlarge)




Let's talk about what UNG did today. UNG nose-dived back down to as low as $10.50 and closed at $10.59. If the previous ratio of the underlying futures contract to UNG NAV is still 3.08:1 (marked down from 3.45:1 formerly) and NG October futures contract closed at $2.98, UNG NAV should be around $9.18. The UNG web site shows $9.12, so I'm close enough for government work. Add in the premium. So lets use UNG site's figures $9.12 + 16.12% = $10.59. Ain't math "wunnerful"? Exactly what we'll see in the chart below.

This dive was accompanied by a couple of unusual "events".

As will be noted on the 1 minute chart of UNG trading for the day, a large price drop on very high volume began at 12:19 and ran through 14:00. Volume for this run was 19.3MM trades. This was 29.8% of the days total volume of 64.7MM trades in a time span of 1:45. Having watched UNG trading many months, I noticed these "events" and the "waterfall pattern" immediately as they were strong variations from the normal observed daily minute-by-minute price action profiles. Even allowing for the volatility of the spot NG price today, which varied up and down at various times in a range of approximately $2.93 to $3.45, this is highly unusual. (Click chart to enlarge)



The few breaks in the down trend were all short and weak and had little breadth, another unusual variation.

Given the volatility of NG today, one might think that UNG could track it pretty closely and be just as volatile. That may be. But I have not observed this type of behavior over several months on days when NG was more volatile than usual. UNG trading tends to follow some general patterns of price swings throughout the day, less sensitive to the minute-by-minute futures or spot price changes of NG and tends to take a final leg down or up to "gravitate" towards the NG-dictated price approaching the end of trading. Seldom are big persistent uni-directional moves seen in the middle of the day. Most moves from late morning through early afternoon tend to have common patterns of up, down, consolidate a bit, repeat. And there will be some runs up $0.20 or so and similar on the way down. But overall, you see trends, breaks, reversals and consolidations over time.

On quiet days, the price range encompasses $0.20-$0.40 or so. On more volatile days, usually swings around $0.70 or so. Both ranges are rough estimates from observation and are not calculated. Regardless, the patterns tend to be as I described above.

The range for today, 9/11, was not highly unusual - $10.50 to $11.37. But the "waterfall" runs downward were quite exceptional. I can't recall ever seeing this pattern occur so sharply and multiple times on a continuous extended down trend in the middle of the day like this, from $11.24 down to $10.50, a 6.6% decline.

That certainly caught my eye. Then something happened.

The new UNG 8-K was listed as EFFECTIVE 2009-09-11 17:02:47. A check of the directory timestamps and the parent directory timestamps are consistent, indicating a high likelihood that these timestamps are accurate and uncorrupted. A snapshot of these items can be seen in the next three graphics. (Click graphics to enlarge)





My first news notification, via my Power E*Trade Pro trading platform was timestamped at 17:06:16 from the Dow Jones Newswires service, as shown in the following screen-shot. The full article of the announcement was timestamped 17:38:28. (Click to enlarge ... I think)



Well, the old "associative processor" kicked right in.

Was this related to the unusual price action I observed in UNG earlier? <Queue the theme from "Jaws" Maestro>

Without access to minute-by-minute NG October futures prices, I have no way to "triage" my thoughts and identify most likely scenarios first. Given all I stated above, you already know that I believe the rise in the NG price was an oddity and had no discernible reason to occur.

That's all I needed.

Was there some manipulation and/or "front running" here? My thoughts followed this path.

• UNG has been working, for an extended time, on a structure and arrangements so that it could begin issuing creation baskets again.
• In this process, there were likely discussions needed with outside parties, possibly consultants, "authorized purchasers", exchange authorities, financial parties, their brokering party, etc.
• Plans would need to be developed and firmed up and, one could assume, coordination with multiple parties would be required to make sure all the ducks were in a row.
• "Loose lips sink ships" and may also leak useful information to interested parties.
• Someone with knowledge of UNG's implementation plans and the wherewithal would be in a position to benefit if they could cause a rise in the price of UNG prior to the announcement.
• The most certain method to do this would be to cause a rising trend over several days in the October futures contracts, using them directly or possibly by working through the spot price.
• This might also be accomplished, regardless of wherewithal, by influencing traders expectations of net injections or other factors indicating a reason that NG prices should be expected to go higher.
• Selling UNG short into the resulting rise, in unobtrusive amounts over several days, would leave one well positioned for the coming downturn. Also if one were long a ton of UNG, this could provide a dumping ground.
• With the enthusiasm for all things NG, sell siders observing the NG/UNG rise would probably get their clients to provide the needed liquidity; they could be completely ignorant of what is going on. But just look at the volume over the last five days. Another nice ramp-up low volume was 46.8MM trades and high was 64.7MM trades in those last five days.

I'd say that was liquid, no?

Well, that's it in a nutshell. Have I gone over the edge?

Should I contact the SEC or CFTC? Or somebody effective?

How about someone's mother-in-law. That would likely be more useful.

I'm not one to lean towards "conspiracy theories" often, but this was just such a golden opportunity.

I look forward to any reasoned critiques, answers that help me along my learning path and other reasonable comments.

Disclosure: long UNG (before problems started), short calls, long puts, long synthetic shorts.

Per a UNG SEC Filing of September 11, 2009, UNG will begin issuing new units on September 28, 2009. The issuances will be limited and subject to terms and conditions laid out in the prospectus referenced by the above link to the SEC filing. The authorized quantity is 1,079,800,000 units.

NB: In the past I had been under the impression that redeemed baskets could be re-issued. I have since discovered this is not correct. When baskets are redeemed, they effectively "vaporize". I can not recall if I ever stated they could be re-issued, but I'm pretty sure I must have said that somewhere because I tend to operate in "brain dump" mode. Anyway, I was wrong.

Now back to our regularly scheduled program.

UNG believes that it can now issue new creation baskets, under limited circumstances, and meet its investment objectives. If circumstances change prior to the new issuance date (again, 9/28) such that UNG believes it can not issue new creation baskets, it will announce such changed circumstances through an 8-K filing as soon as practicable.

The terms and conditions for new issuance of creation baskets include:

• authorized purchasers must agree to sell specified investments to UNG, that are accepted at the sole discretion of UNG, that meet UNG's investment objectives, including fully collateralized OTC swap arrangements, of certain size and duration, whose counter-party meets UNG's creditworthiness and diversification standards and any other other terms UNG determines to be appropriate, at the sole discretion of UNG;
• UNG may limit sale of creation baskets to various minimums or maximums for any authorized purchaser;
• UNG may vary the terms and conditions of the investments to be delivered or arranged by an authorized purchaser;
• UNG may decide to offer creation baskets only on particular days; whether or not an offering will be made; what will be the terms and conditions for that day; those terms and conditions will be announced each day no later than start of trading in UNG on the NYSE ARCA.

As the caveat to the investor, the prospectus states that the effect on premium over NAV is not predicted and that additional losses may occur if an investor bought or buys at a premium and then sells when the premium is lower.
UNG also warns that the new issuance process may involve fees in excess of what was incurred in the previous process of rolling futures contracts, increasing the expenses and tracking error. However, in the prospectus, UNG does not offer any speculation or expectation of what these fees may be or to what degree they may increase.
WEAK ANALYSIS: What does this mean to those holding UNG or thinking of entering UNG?

• Premium of 0% is increasingly likely now, especially after September 28. At end of 9/11, premium was 16.12%.
• The conditions UNG is imposing on authorized purchasers seems a strong attempt to control and minimize counter-party risk, which was not needed in the previous futures contracts scenario. How effective this really is depends on the quality of execution by UNG - credit history checks, review of long-term history of the counter-party, current financial status, risk assessment, etc. Your faith in the ability of UNG to properly carry out these risk assessments and ameliorate such risks should be a part of your investment decision-making process.
• The flexibility to issue creation baskets on an "as desired" basis seems intended to allow UNG to ensure it can comply with any CFTC limits that may be imposed while protecting against "breach of contract" issues with the authorized purchasers if UNG bumps up against any CFTC-imposed limits.
• All the above seems to reduce risk of nasty government-imposed surprises causing the investor losses over-and-above those that might be suffered in a "normal" environment (is there any such thing in this "Brave New World"?).
• I believe the previously published expense ratios are no longer reliable figures - future expenses will likely be higher. This has implications for long-term holders of UNG units.
• Since OTC swaps are replacing futures contracts, I had hoped to see if a "roll" was still to be used and how and when. None of these were addressed in the new document.

RECOMMENDATIONS: In the past, I've stated my opinion that UNG is not an investment vehicle, but a trading vehicle. I believe it is more so now because the expense ratio is unknown, the expense, timing and effect on NAV seems unpredictable with the currently available information, and the effect of the uncertain frequency and (in)consistency of new issuance on premium to NAV and market price seems unpredictable for now.

Combined with considerations I've stated in past articles, and comments I've posted in articles by others, I suggest the following.

• If you are investing long-term, do not enter at this time. Wait for a while, see how things behave and review one or more subsequent 8-K reports to determine if the vehicle is suitable for your purposes. Do keep in mind that in a couple months (that's optimistic - I believe it will take until the first quarter of next year at least) the contango may be substantially reduced or we may even see backwardation. If you want to get into UNG be prepared to enter as this situation approaches as roll will then gain "contracts" rather than losing them.
• In any case, be sure and use covered calls and/or puts (I prefer calls to rake in options premiums rather than paying out cash for protection) to help reduce effective cost, collect premiums or provide downside protection.
• Keep in mind that prices seem to get the lowest during the roll periods 60% or more of the time. Plan your moves around these points, keeping in mind options expiration dates so you are aware of possible short-covering and so you can roll your options (short calls), if you use them, and/or lock in gains. Actually, I would not "roll" if I believed there would be appreciable price rises after the roll period. I would close the short option(s) at what I think the low is and later enter a new covered call position when I think the price is up near a near-term high. Of course this only works if you have confidence that you are familiar enough to spot the trends and "time" your actions.
• If your options positions are long puts, you want to buy at what you believe is a high price for the underlying UNG units and sell the options when the underlying UNG units are at a low price to take profits. Of course you can also hold and then exercise them if you feel it is your preferred option.
• Remember that time-decay is your friend if you are short calls (e.g. covered calls) and is your enemy if you are long puts. It's best to use an option calculator, such as provided freely at the Options Industry Council web site, to plan your entry and exit points. If your trading platform provides one, as mine does, that should suffice.
• Professionals normally suggest that us little guys do not attempt this. I will not dispute experienced folks. However, I do freely ignore them all the time.

CAVEAT: with so little knowledge about what exactly the OTC swaps do, I can only assume that UNG is structuring these positions to closely emulate the effects obtained in the past, via futures contracts. This is an assumption by me and may be incorrect and the observed effects may vary significantly from those observed in the past.

If you are an experienced trader, it would be presumptuous for me to make any recommendations since it is likely you are more experienced than I. So I will not suggest any more than I have in past articles and comments.

Disclosures: long UNG, covered calls, long puts and some synthetic shorts.