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FCG: The Right Fund for Natural Gas

|Includes: FCG, The United States Natural Gas ETF, LP (UNG)

 

U.S. Natural Gas (NYSEARCA:UNG) was the ETF that gained the most investor capital in June, a whopping $1.7 billion. Overall, investors added $12.1 billion to ETFs in June, meaning UNG accounted for 14 percent of new money.

 

The flow into UNG was even more impressive in percentage terms for the fund, as assets under management swelled from $2.2 billion to $3.7 billion in a month when UNG declined 5 percent. It also proves that investor interest isn’t always enough to push prices higher.

 

Investors poured into U.S. Natural Gas (UNG) last month, and for their efforts the fund has been dropping off. It isn’t a great vehicle to short natural gas, however, because the fund’s issuer recently suspended the issuing of new shares pending regulatory approval for a massive expansion. This means that if there are more buyers than sellers (and interest has been strong, as I’ve noted), shares are likely to trade at a premium, even if the price of natural gas declines—something the fundamentals and technicals would imply.

 

Even though the fund is a huge portion of the futures market, it is not a large portion of the overall natural gas market. Economic weakness in the manufacturing sector, consumers tightening their belts and a cool summer in many parts of the country are all playing a role in lower natural gas prices. Additionally, natural gas is produced domestically, and in the absence of a natural gas cartel in this country and aside from drilling restrictions, the market is relatively free

 

Overall, the frenzy into UNG was based on speculation that natural gas would follow oil, and that the ratio between crude oil and natural gas prices would shrink from extreme levels back into the historical range. Ratios have two ways of closing though—the undervalued asset can rally, or the overvalued asset can decline.

 

Problems with the Fund

UNG invests in front-month natural gas futures contracts that trade on the New York Mercantile Exchange. The value of the contracts is tied to the spot prices for natural gas delivered at Henry Hub, La. Natural gas is difficult to transport, so futures provide a good trading environment for investors unable to own the commodity directly. As the calendar catches up with the contracts, investors are forced to "roll forward" their investments into a later date, so UNG rolls its current contracts into the next month's contracts on a regular basis.

Secondly, as each month draws to a close (the ETF is big on futures-based trades), the fund rolls over to the next month's contract, and so forth. When the prices of those out-month contracts exceed the price of the near-month contract (known as a state of "contango"), the fund loses money each time it rolls futures.

 

So, essentially, contango slowly rots away the value of your initial investment over time as one month rolls to the next. The winners in this situation are traders with access to both paper and physical commodities, not UNG holders.

 

Furthermore, as the demand for UNG rises, authorized market participants (modern day ETF specialists) create units of the fund to sell to individual investors in large blocks. Since they are not allowed to stay “short” the fund for long, these authorized participants are constantly trying to create enough shares ahead of time to anticipate the market’s demand. Authorized market participants deliver the securities in the underlying basket, or equivalents, in exchange for blocks of the fund– interest in UNG has expanded so rapidly that the fund now wants to issue 10 times the number of shares now available.

So holdings in funds like UNG can get so large that the funds actually move the markets for the contracts when the fund managers roll the contracts to the next month.

 

Finally, given that ETFs have attracted a tremendous amount of attention due to their transparency and ease of trading, the complexities of commodity ETFs and ETNs are often glossed over by issuers eager to market alternative investments to a crowd that is willing to break away from the equity markets.

 

Another Option

 

For investors looking at the big picture, however, and looking to gain exposure to a growing natural gas industry in the long term, FCG is a better choice. On Tuesday, June 7, U.S. Commodity Futures Trading Commission Chairman Gary Gensler noted that the agency will hold hearings this summer to consider imposing position limits for "all commodities of finite supply." As swap dealers, index traders and exchange-traded fund managers are examined to determine whether hedge exemptions should apply, resulting regulation could stem the growth of futures-based ETFs in a dramatic way.

 

FCG contains shares of companies that are involved in the exploration and production of natural gas. The top three holdings in the fund are Linn Energy, LLC (LINE), St. Mary Land & Exploration Company (NYSE:SM) and Chevron Corporation (NYSE:CVX).   While this fund may be one step removed from the “pure” play of futures-based ETFs, it owns shares of companies, which may be a more “solid” and reassuring feeling for long term investors than ETFs that own expiring contracts. Rather than speculation, the companies in FCG’s portfolio are selected based on Price/Earnings ratio, Price/Book ratio, Return on Equity and the correlation to gas futures prices. Furthermore, FCG components must satisfy market capitalization, liquidity and weighting concentration requirements.

 

FCG helps to protect your portfolio from speculators by taking a step back from futures prices. Both leveraged and futures-based ETFs are destined to come under more scrutiny in the future for their structure and hedging exemptions. For investors looking to avoid this mess, but still wanting take advantage of energy demand, FCG may be the answer.