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Five Thousand Over Libor
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Energy trader with 11 years of experience in Natural Gas and Interest Rate markets. Manage a small trading organization, in the $25-50 million asset range, responsible for both consumption/production hedging and proprietary strategies.
  • UNG: A Deeply Needed Proper Explanation 1 comment
    Sep 2, 2010 2:36 PM | about stocks: UNG
    I wrote and had this article originally published in early April this year. I am including it here on my SA site.  I believe it to be one of the original ariticles addressing the short-storage exposure of UNG.

    While I cannot claim that every source of financial media has failed in attempting to fully assess the rot that represses UNG (UNG), I can assert that every source I have been made aware of has.  Although most are not incorrect, they are incomplete, often going 2 of the required 200 feet to fully understand what is wrong with UNG and every other ETF that employs a long-only, prompt-only consumable-commodity futures strategy.

    UNG carries prompt-month gas futures, perpetually, through time.  Carry and carry and carrying away, in essence morphing long-term UNG holders into Natural-Gas Sherpas.  While none of UNG’s activities are in the physical arena, the profit/loss profile of their strategy is identical to holding physical length for 30 days and then contracting to carry it – at going market rates – for another 30 days.  Rinse and repeat.

    Carrying natural gas (and most other consumable commodities) is not an activity free of expenses.  Storing this fuel costs money.  How much?  It depends upon who you ask and what modified form of “carrying” you are involved in.  If you owned a parcel of physical gas and contracted to hold it in a storage facility until January, you would pay an explicit, determined rate to an actual pipeline/storage operator.

    If, however, you are involved in a strategy of constantly holding prompt Natural Gas futures, your storage cost (you probably didn’t even know you had one) is far less obvious.  This is where that frightfully odd sounding word “contango” comes in – a property absolutely foreign to almost all non-futures participants until the advent of these Bouncing Betty ETFs.  

    Contango refers to a specific shape of a forward futures curve – where deferred deliveries are more dear than those previous.  Contango exists for many reasons but primarily to encourage storage of a consumable commodity.  Absent this storage we would all suffer perpetual lapses of surplus and deficit of supply in the given commodity’s spot market and the concomitant extreme price volatilities that would result (watch spot electricity prices for a vision of a future without storage).  For many consumable commodities, contango is the norm.  Natural gas is no different: over the past 5 years the spread between the first and the second months has had a contango settlement 1,178 of the 1,257 trading days – or 94% of the time.  Since NG futures inception at NYMEX in April 1990, 80% of all daily settlements have been in contango.

    UNG, therefore, (and any other long-only, prompt-only consumable-commodity futures fund) has twin exposures:
    1)      The obvious: Long Natural Gas - in the form of the futures, swaps, and total return swaps it carries
    2)      The not-so obvious: Short Natural Gas Storage - in the commitment it has to sell prompt and buy next-to-prompt gas each month.

    It’s the short-natural-gas-storage exposure (wholly naked at that) that many completely missed when this ETF first rolled out and that many in the media now inaccurately describe with statements such as “UNG bought fantastically rich forward contracts, and then rode them all the way down to spot”.  This misses the point - the problem with UNG's structure is virtually independent of the price she secured her previously-purchased gas.   The problem is with a vastly-dominating positive prompt 30-day storage cost.  To wit: the largest singular monthly problem that UNG ever suffered was taking her OCT 2009 gas 30-days forward into NOV 2009 last year, and “paying” $1.00 per MMBtu to do it.  On $3.20 gas (OCT 2009 avg price on their roll back in September), that’s a 31% notional carry cost – for 30 days.  They bought that OCT at around $3.75 a month earlier – a price near 7-yr lows at the time.  Fantastically rich is not a prerequisite for the pain of UNG.

    Storage costs for UNG will always accumulate faster than the gas that UNG carries can appreciate over time.  Why?  Because natural gas prices oscillate about a marginal cost to produce and that marginal cost to produce does not advance ad infinitum. Things, like technology, interrupt advancing costs (horizontal drilling being a strong example). Storage costs, on the other hand, will steadily accumulate throughout time with little interruption. As stated previously, the front 2-month spread in NG has been in contango 80% of the days since inception in 1990.  This worsens to 87% and 94% for the past 10 and 5 years, respectively.  This eventually renders UNG worthless and is expressly why no entity/fund/person in the futures market has ever deployed a perma-long, perma-prompt strategy prior to the advent of these ETFs.

    Now, UNG never explicitly “pays” these “storage costs”, they simply lose gas each roll – they pay for the storage by taking less gas with them every 30 days.  But the exposure is short storage, as that is what UNG is, a vehicle that carries gas for 30 day clips that will continue until the fund eventually “spends” all of its capital on NG storage.  This will manifest with UNG simply running out of gas - literally.

     UNG works well for those seeking short periods of prompt natural-gas exposure.  It is utterly ruinous for long-term holders – as long-term length in UNG is nothing but being a Natural-Gas Sherpa.  UNG is capable of sustaining advancements in price, in so far as NG prices are advancing faster than storage costs accumulate.  But in this new era of Shale Gas, where storage is the constrained variable, not production, the prospects for such developments are bleak.    With UNG in the Shale Gas Era, you are short the constrained and long the plentiful – not an advantageous place to be.




    Disclosure: No Position in UNG
    Stocks: UNG
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  • xmomba
    , contributor
    Comments (9) | Send Message
     
    After much effort and time, your original article was the first I found discussing and explaining UNG's terrible structure and its effect. For that, I'm grateful.

     

    It makes your wonder how many unsuspecting "buy and hold" folks have gotten hammered from not knowing this information.

     

    I personally think those recommending UNG without disclosing the effects of contango are reckless at best. Of course this assumes they know this themselves, which I often suspect not.
    7 Sep 2010, 09:12 PM Reply Like
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