Shep52's  Instablog

UNG: Over-Shorted?

UNG is perhaps the most heavily shorted security in today's market. At the same time, very few investors know how heavily shorted it is because it's hard to find the short interest numbers on it.

It pays to understand how UNG is shorted. UNG allows certain broker-dealers to buy (create) or sell (redeem) UNG shares to the fund on a daily basis. If a b-d buys/creates shares, they also agree to sell near term month futures to UNG at the day's settlement price. Thus, the buyer is making no bet whatsoever regarding the price direction of the UNG shares themselves (since if they buy shares, they are also short futures). If UNG goes up, they make money on the UNG shares, but lose on their futures short. Sales/redemptions work exactly the same way.

Thus, the only entities that are buying or selling to UNG are firms that are loaning the shares out to short-sellers and charging some nice fees for doing so. They bear no risk as to the price movement of UNG, as they're both long and short natgas.

When a firm creates/buys shares, UNG gets cash (which they use to buy futures contracts) and the fund's float increases by the number of shares purchased. Redemptions have the opposite effect.

These purchases and sales have been going on for years. However, starting in 2012, the number of purchases saw huge increases. To illustrate:

The interesting thing about these numbers is that the short interest seems to track the purchases, but the redemptions do not seem to have any effect. For example, short interest reported as of February 29 was 10,091,300. Short interest as of March 31 was 22,244,900, an increase of 12,153,600 shares. However, only 3.2mm net shares were created in March, while 12.4mm were created.

Logically, one would assume that the redemptions represented short sellers covering their positions and then the broker-dealer unwinding the prior purchase of shares from UNG - thus redeeming them. But the logarithmic increase in short interest this year (while net created shares haven't kept pace) tells a different story. I believe that the redemption figures represent some short covering. The balance represents market makers who have had to buy the shorted stock in the open market for months and have such large positions that they are forced to unwind them by selling the shares to UNG and buying natgas futures that they shorted when they bought the UNG stock originally. Thus, the short interest continues to increase more than the net number of purchases directly from UNG increases.

Until recently, UNG only reported the net number of shares created each day. Now, they report both purchases and sales separately each day and on a monthly basis.

The actual float changes every day depending on the number of shares bought from or sold to the fund. As of December 31, 2011, the # of shares outstanding equaled 41.4mm (reflecting the February 2012 reverse split). As of May 10, 2012, that number increased to 52,866,476. As of May 10, short interest represents a whopping 82% of the float.

The most recent NYSE short interest list shows that UNG has the 40th largest short position of any NYSE stock and had the 14th largest increase in short interest since the last report. Of course, there are many stocks with far more shares outstanding than UNG. As a percentage of the float, I doubt there is any stock in the market more heavily shorted.

No matter what you think what the true fair value of natural gas is, you simply cannot maintain a stock where every single share has been shorted. It will either go to zero (which is what the shorts were hoping) or it will have an incredible move up on the backs of the shorts.

The key is to pay attention to the daily creations/redemptions and the trend. When you see a large amount of shares being created, that means a bank or a fund is planning to attack UNG to drive it down in the next few days or weeks. If you see a large number of redemptions, just the opposite. It's not an exact science, but these numbers are pretty telling.

What is the role of UNG Fund managers in respect to the shorts?

Unfortunately, UNG's managers are causing these problems. Allowing firms to buy an unlimited number of shares, is in essence creating an unlimited supply of stock for people to short. Take this to the absurd. Say there were 100 shares of UNG outstanding. Now, a short seller buys a million shares from UNG so he can short the stock. Obviously, UNG would never go up, as the supply would simply crush any demand at any price. And that's exactly what's been happening for 4 years, and has accelerated in 2012.

UNG benefits from issuing shares because their management fees are a percentage of the assets under management, which depend on two things: 1) the performance of the fund and 2) the net number of created shares. Since everyone knows the performance of the fund has been abysmal since June 2008, UNG would have almost no assets to manage if not for the short sellers. Ironic, huh?

What happens when someone shorts UNG?

The great majority of the shares traded on a daily basis are changing hands between market makers and short sellers. When a short seller shorts UNG, chances are a market maker buys the shares. The market maker in turn then shorts an equivalent amount of near month futures contracts to hedge their position. Thus, when a short wants to put pressure on the futures, they dump a large number of UNG shares on the market, forcing the market makers to sell futures, driving down the price. As you can see from the recent action, buying causes just the opposite effect.

The fund is worth approximately $905,000,000 as of May 9, 2012. At 82%, that represents approximately $720mm of shorts having to buy UNG at some point. I am comfortable saying, based on the reported numbers, that the great majority of these shorts have not covered. The bottom line is they will have to cover some day. Just like the aapl shorts covered at $644.00.

Disclosure: I am long UNG.

The United States Natural Gas Fund (UNG) is an ETF that tracks the front month natural gas futures contract. That is, until it sells that contract to roll over to the next month's contract. This happens according to a schedule published on UNG's web site and usually happens in the middle of each month.

In between the rolls, UNG tracks the front month natural gas futures contract PRECISELY. Due to the effect of serious contango over the past four years, UNG suffers losses as a result of contango each month. Of course, these losses are in addition to the losses that natural gas has experienced since 2008.

Everyone believes that the price of natural gas is simply the result of supply and demand in the marketplace. I heartily disagree. Yesterday, the average spot price at Henry Hub was $2.2682. A month ago, it was $1.99. Have the supply/demand metrics changed so much in a month to account for this large price swing? No.

Open interest in the July futures contract was 234,831 as of yesterday. This represents 2,348 Trillion BTUs of energy (234,841 x 10,000MM BTUs) or approximately 2.4 Trillion cubic feet (1000 cubic feet = 1 MM BTUs approximately). Monthly gas consumption is approximately 2.1 Tcf per the latest EIA Short Term Energy Outlook. That the open interest exceeds monthly consumption indicates that the market is dominated by speculation.

In a perfect market, the price of goods or services is determined by the intersection of supply and demand. However, the natural gas market is anything but perfect. Think about it. Why is the near month futures price of natural gas 55 cents higher than it was just a month ago? Are consumers of natural gas using that much more gas today than they were in April? No. Are producers of natural gas that much less willing to sell natural gas this month than they were last month? No. In the short term, both supply and demand are relatively inelastic. To reduce supply in the short term, you have to either cap a well or reduce the output of the well-something producers are loathe to do for various reasons. You cannot stop adding to the supply otherwise. In the short term, consumers do not change their usage habits that dramatically (in the absence of severe weather).

The price of natural gas (and thus UNG) is determined by speculators, just as the price of oil is. For almost four years, those that dominate the futures markets (the banks) made money hand over fist shorting natural gas. They took advantage of the CFTC's unwillingness to enforce position limit rules to flood the market with supply, driving prices down inexorably. Profits at the money center banks for their commodity desks soared. Producers were helpless to do anything about it and consumers (utilities) had no problem with cheap gas.

However, the speculators drove the price down so low that producers could no longer produce gas profitably and are shutting in wells and foregoing E&P investments in new wells. As a result of the declining forward futures price strip, producers could no longer hedge at a price greater than their costs to produce. At the same time, utilities were increasing their energy mix percentage of natural gas and buying futures aggressively to lock in low prices for months to come.

An inflection point finally hit. Consumption has skyrocketed and production is finally starting to abate. Today's price does not reflect today's supply demand balance (or imbalance). It reflects that sooner rather than later, there will be no gas available for sale at $2 and sooner rather than later, the price of natural gas will exceed $3/MMBTU.

Buyers increase their purchases, fearing future price increases and increasing demand at a time when producers can no longer rapidly increase supply.

In a world where there is such inflection, price changes take place rapidly. Prices for near term supply increase rapidly and future month prices do not rise as quickly. The result: less steep contango and even backwardation.

In any market, the key is to recognize an inflection point and act accordingly. I believe we have seen that inflection point.

Later this week, I'll post how short interest has added fuel to the fire of this inflection in the natural gas market.

Disclosure: I am long UNG.