UNG: Over-Shorted?

May 10, 2012 2:51 PM ETUNG
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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:



  Purchases/Create Sales/Redemptions Short interest month end Float Short % of Float
January 2012 2,700,000 3,575,000   40.5mm  
February 2012 7,250,000 3,750,000 10,091,300 45.37mm 22.2%
March 2012 12,400,000 9,200,000 22,244,900 48.57mm 45.8%
April 2012 16,200,000 12,700,000 37,293,488 50.0mm (e) 74.6%
May 10, 2012 6,200,000 5,400,000 43,493,488 52,866,476 82.3%

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.

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