My Natural Gas ETF Report
- UNG is NOT a double inverse fund
- Dancing the contango
- How to play the trend
I’ve been teasing a full write up on why I think the United States Natural Gas ETF (NYSE: UNG) may have been designed to lose money. If you’ve had the misfortune of owning this ETF, you are keenly aware of this tendency. In the past 9 months, the price of natural gas climbed off the floor of $2.75 per thousand cubic feet up to nearly $4.25 today. That’s a 55% gain. In that same time period, UNG lost 27%.
As a reminder, UNG is NOT a double inverse ETF, but you wouldn’t know it from looking at those results. That brings me to crux of why this ETF does not perform the way you might expect it to, and how you can avoid making investments in similar ETFs that are more tar-pit than gold-mine. After all, the first rule of investing is “Don’t lose money.”
Investors typically think of ETFs as baskets of equities, with performance naturally reflect the rise or fall of the value of those stocks. UNG is structured a bit differently than other ETFs available to the public. According to the United States Natural Gas fund website:
"The investment objective of UNG is for the changes in percentage terms of the units' net asset value to reflect the changes in percentage terms of the price of natural gas delivered at the Henry Hub, Louisiana, as measured by the changes in the price of the futures contract on natural gas traded on the New York Mercantile Exchange that is the near month contract to expire, except when the near month contract is within two weeks of expiration, in which case it will be measured by the futures contract that is the next month contract to expire, less UNG's expenses."
Okay, that’s a mouthful.
In other words, the value of the fund is driven by front month natural gas futures exposure. To ensure continuous exposure, the fund’s administrators "roll" their front month futures contracts to the next month as expiration approaches to avoid taking physical delivery. Many ETF investors incorrectly assume that UNG attempts to track the return of natural gas spot prices – but this couldn’t be further from the truth.
To explain this process further, I’ve enlisted the help of one of the best traders I know: Eric Adamowsky.
Eric explains:
”The primary reason UNG experiences such large losses EVEN when natural gas prices rise is the fact that the natural gas market is usually in contango. Contango is just a fancy word that describes a situation where the future prices of natural gas are higher than the spot prices. UNG fund managers are forced to sell near month contracts (also known as "rolling" contracts) for less than the cost of back month, or second-month futures. This inevitably results in a loss of exposure to natural gas. The UNG fund more or less pays a "premium" to roll the contracts to the next near month to avoid taking physical delivery. Every time they buy the next front month and sell the current month natural gas future, they do so at a loss when prices are in contango – which they usually are!
Contangoed markets are generally a result of higher storage costs, as in the case of natural gas which has extremely high storage costs. Higher future price expectations from market participants also cause a market to become contangoed Whereas a barrel of oil can sit in a barrel in perpetuity, if you want to store natural gas you need miles of pipeline and humongous high-tech gas storage tanks. It might be the most expensive commodity to store, so there are very few circumstances when it’s not in contango.”
Here’s a table of contangoed nat gas prices:
Looking at this chart, you might think “Well, I’ll buy the June future at $3.93 and sell the December contract for $1.25 profit.”
That’s a common misconception – but what really happens is that as you get closer to December, that contract will go down in value. Unless there’s a huge supply crunch or some other market disruption, your December contract will probably come within pennies of what you paid for the June contract, as future contract prices eventually settle to spot price levels.
Furthermore, unless you can invent a way to store one thousand cubic feet of natural gas for free for the next 7 months, your storage costs will gobble up any price appreciation. That’s contango: natural gas costs more in the future, not because prices are going to necessarily go up – but because it’s expensive to store natural gas for any period of time. The longer you hold the contract, the more you’re paying for that storage. Natural prices could go up, and if you own the December contract you could certainly make some money, but prices would have to appreciate MORE than the current contango discrepancy of $1.25.
Of course, I don’t advocate buying and rolling natural gas futures – but that’s exactly how UNG is structured. For whatever reason, the fund is set up so that the ONLY way it can turn a profit is if prices are not in contango, that is, if front month prices are higher than subsequent month prices.
It can happen, and when it does, it’s called backwardation, and it’s the result of unexpected supply and demand action in the market for natural gas. On the inverse, if the natural gas futures are in a state of backwardation, UNG may actually benefit from this condition. I don’t know about you, but I want to make money from the expected, not the unexpected.
I do expect natural gas prices to rise in the future – but UNG is not the way to take advantage of the trend. It’s counter-weighted to resist profitability. ETFs can be a great way to gain exposure to a variety of sectors, and not all of them are designed to lose money, but you owe it to yourself to read and understand how they are designed. If you don’t understand how they’re set up for profitability, it just might be that they’re not going to be profitable.
I’d also advise against investing in an ETF that trades futures – unless you feel like you have a strong grasp on how they work. Not to get into too much detail, but every futures contract is a derivative – and some ETFs will trade options on those contracts – which means they’re trading derivatives on derivatives.
Why make it so complicated?
If you’re bullish on natural gas, for instance, I recommend buying strong natural gas companies at cheap valuations. In the Energy World Profits portfolio, we’re currently recommending the largest independent natural gas company in the U.S. This company has the most natural gas, with the most active wells, and will stand to benefit immensely from any upside in natural gas prices. If you’re interested in finding out the name of this company, I’d like to give you a free trial subscription to Energy World Profits. You can take me up on this offer by clicking here now.
Good investing,
Kevin McElroy
Editor
Resource Prospector
