Waiting for UNG's New Issuance to Prove Itself

Includes: ABE, UNG
by: H. T. Love

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.

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