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Structural Flaws of Commodity ETF's and opportunities offered by said flaw

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

Ah the glories of commodity ETF's and the misconceptions but glorious opportunities that

are created by those same misconceptions.  What misconception do I speak of, the idea that

commodity ETF's (that purchase underlying future contracts) actually track their commodity

over a long-term period of time which is proven mathematically to not be the case when

contango is present.  Opportunities that are created are numerous but mainly in lie with

being bearish on that commodity ETF.  My favorite and one I am almost always constantly

trading is UNG which tracks prompt month natural gas future contracts. 

However, first off Natural Gas is a domestic commodity that has no real influence from

other nations other than imports of Natural Gas from Canada and LNG imports via ships. 

This does have an impact on supply which we will be getting too.

Overall, natural gas is currently in an oversupply environment which leads to an eventual

price ceiling (as more supplies come online at higher prices which work to drive prices

down) but also leads the natural gas market to be in contango.  All sorts of historical

future pricing data is available on EIA's website (from 1991 to current) for free.  However

the invention and success of horizontal drilling or "fracking" has led to increased

production of natural gas from rigs as well as increased production from each rig itself. 

There are a myriad of reasons why Natural Gas Producers can not stop drilling but this is

not the point of this discussion.

So given this view, which is relatively common and widespread among natural gas firms, one

could expect a natural ceiling on prompt natural gas prices to occur.  Shoulder seasons

would be a different beast (spring and fall) in terms of pricing than summer and winter

when heating/cooling demand causes increased demand of NG usage.  So with the summer coming

into an eventual close you could see natural gas prices further decline from U10's current

price of $4.328 (settlement date of 8/13), but even in my bearish eye this is not a

compelling risk reward spot to put on bearish trades on Natural Gas. 

Here comes the opportunity presented by UNG the "Natural Gas Commodity ETF".  UNG aka

Natural Gas is entering into the heaviest periods of contango during the calendar year. 

The heaviest contangos normally lie within the "Victor-Foxtrot" or V-F (know hereafter as

V-F) spread in Natural Gas Future Contracts.  The current V-F spread is made up of the

October-January Natural Gas Futures Contract.  As of 8/13, the V-F is at  $4.35-$5.002 or


UNG is currently rolling from U10 Natural Gas to V10 Natural Gas for a spread of $0.022

($4.35-$4.328).  However to UNG this represents a decline of possible price increase of

0.51% as UNG now or would own $4.35 NG instead of $4.328.  By having to roll UNG forgos the

possible price increase from $4.328 to $4.35.

However UNG would have to roll from U-V, V-X, X-Z and Z-F, which has contango costs of

$0.022, $0.235, $0.284 and $0.133, respectively.  This adds up to be 15.57% contango. 

To make it really simple you can view contango as a "headwind" that lowers the possibility

future gains of UNG in a rising Natural Gas Price Environment.  In a flat price environment

this would cause a loss of the amount of contango.  In a declining price environment it

represents a double edge sword as UNG loses the % of the price decline as well as the % of

contango paid.

Without presenting a neutral/flat price scenario or bearish price scenario for natural gas

prices I am going to present my "bullish" Natural Gas Price Scenario with the current

contango spread of U-F (Sept through January) of 15.57% remaining as a constant.  A note,

that 15.57% contango is an assumption and could easily change but to create any future

scenario (educational purposes) one has to always "create" assumptions.  I do not like the

taste of doing that but it is a necessary evil to illustrate the problem of commodity


Lets say natural gas prices during F11 reign as prompt contract should be at $4.7608 based

on a mild winter.  That would represent a 10% increase over the current U10 price.  So UNG

should trade at $8.008 correct (UNG closed on 8/13 at $7.28).  There in lies the problem

with contango, UNG would actually be trading at $6.87.  But wait, didnt NG prices go up 10%

from today 8/13.  Yes but there was 15.57% contango during the same time.  Thereby UNG

didnt gain the 10% in price increase as they would pay 15.57% in contango. 

My bullish expectation (not really a NG bull more of a short-term NG neutral aka range

bound proponent) would probably see NG prices during F11's reign would be from $5.60-$6.06.

 That represents a 30-40% increase in NG prices compared to the current $4.328 U10 NG

price.  With contango UNG would trade for roughly $8.33-$9.06 instead of $9.464-$10.192

thanks to the current 15.57% contango.

So if I can "see" a bullish expectations for $5.60-$6.06 NG which would equate to $8.33-

$9.06 (with the contango) why wouldnt I go long UNG or recommend it.  Why, because thats my

bullish view and I am not really a "bullish NG person" in the short-term.  Even if NG

prices reached those levels I would view that as an excellent opportunity to bring in a

short position as the spring shoulder season could see NG prices on a prompt basis reach

into the low $4.00 price level maybe even $3 like we did this spring.

So the best probable trade to put on is call credit call spread or bear call spreads.  You

short "a lower strike call and buy a higher strike call" in the same month for a net

credit/premium/cash received.

An example of this, The current $8-10 bear call spread in the UNG January 2011 contracts

trade at $0.61-$0.25 for a net credit/premium/cash of $0.36.  So you would be getting short

UNG at $8.36 or the equivalent of $5.60 F11 NG on the assumed scenario.  Not super

compelling as your maximum upside is $0.36 against $1.64 maximum value at risk and in a

short-term price spike may trade up as high at $0.80 or $1.00. 

However one could await for spike in NG prices to put on a trade similar to this. 

Myself and my recommendation is to wait for a price spike to "put on" a bear call spread on

UNG.  These should be OTM and should match your view for a "peak" price of NG based on your

assumption of what contango would be and the impact it would have on UNG.

A disclosure, I am long calendar put spreads on UNG and have bear calendar call spreads on

UNG.  It carries a minimum negative delta currently as I have been taking profits on the

recent price decline in NG.  In the short run I expect an increase in price but I dont know

the time frame or how much it may occur if at all.  At that time I will be initiating more

bearish positions on UNG primarily through OTM bear call spreads or naked call options.

I disclose all of my positions on the message board for UNG under

jewolf2182 but use the alias of "Wolf" on the board.  Search for Wolf Trade Update and you

will find all of my trades in 2010 and my current positions in whatever ratios they may be


So the point of this article, look for a possible increase in NG prices in the short-term

and be prepared to get into OTM bear call spreads out in Oct or January option expirations

for UNG based on your expected peak NG prices during the winter. 

As said this article was written with a slant of my "bullish NG price" expectations for NG

this fall/winter even though I am more of a NG range proponent or neutral price NG. 

However for those people who dont have access to futures or dont want to take on the risk

of playing those ranges bullishly or bearishly, they cant take advantage of UNG's

structural flaw (contango) and take the "most probable" approach to profits which is via

OTM bear call spreads on UNG.  These probably should not be placed at the current time as

the risk/reward isnt as compelling as it may be if one were patient.

If one isnt patient and wants to jump in, maybe do so with 20-30% of the maximum size you

want to have at risk.  That way you can scale into 100% of your size at higher premium

prices or further OTM bear call spreads.  So if you started with the January $8-10 bear

call spreads you could add additional spreads to that or add new $9-11 or $10-12 bear call

spreads to take advantage of price spikes.

Also the 15.57% contango may increase to 30% this fall to where one probably should be

shorting now.  However contango may decrease to sub 10% (unlikely in my opinion for the U-F

rolls).  My expectation of contango for the U-F rolls would probably fall into 12-30%. 

Hurricanes and an extended heat wave into the fall would impact both contango and natural

gas future prices.

I will be doing follow up pieces to see what is going on and when I feel it is time to place those OTM bear call spreads. 

Disclosure: Have bear calendar call spreads, long calendar put spreads leaving a mild negative delta (bearish) position on UNG