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UNG: Why Contango Doesn't Matter

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

Much has been said about UNG and its rather dismal year.  I'm certainly glad that we did not hold any shares of it at the beginning of the current year.  As of this morning, UNG is off nearly 50% from its January 1st value.  Many commentators are intent to blame the effects of contango for the fund's troubles.  This view is incorrect.

For starters, lets take a look at what futures contracts are.  When you purchase a futures contract, you are buying a certain amount of a commodity (in this case, Natural Gas) and you are agreeing to take delivery sometime in the future.  If the price of the gas goes up, you save money, because you locked in your price when you bought the contract.  If the price goes down, sadly, you overpaid.  Investors and speculators skip the delivery stage and sell their contracts before they take delivery.

In a normal futures market, one should expect prices to rise the farther into the future the contract goes.  That is, a 6-month contract should cost more than a 3-month and a 3-month contract should cost more than a 1-month contract.  If prices become inverted so that the longer-term contracts become less valuable than their shorter-term cousins, we have an "inverted market."  Inverted markets do occur from time to time, but investors beware: An inverted market is not the same as contango. 

In layman's terms, an inverted market is like a family photo.  It takes a snapshot of several related contracts at a single point in time.  Contango is more like a video you might make of one of your children.  It only watches one contract and how it behaves over time.  Remember our example of overpaying because the price fell? That was contango.  When the contract expired, the spot price was lower than what we paid for the contract.  Its that simple.

Back up to a time before speculators when the main use for futures was to allow consumers of a commodity to lock in their price in advance.  If Joe needed 100 units of gas in 3 months, he could buy a 3 month contract or he could buy 1 month contracts and roll them over at the end of the month.  Suppose Joe buys one month contracts for $1 and the spot price goes down to $0.90.  He sells his contracts for $0.90.  But when he rolls over into a new contract for $1, he only gets 90 units.  That's not enough! Joe needs 100 units.

Contango is a problem for guys like Joe, who need a certain amount of units on a certain date.  For investors who can wait out the bad months, contango is a non issue.  When UNG rolls contracts over after a down month, investors still have the same amount of dollars (minus transaction costs) and dollars are what matters.

Disclosure: Long UNG