Could the natural gas ETF (UNG-NYSE) lose its tracking of natural gas prices? In one very specific (and quite realistic) circumstance, it could. And could it possibly skew the real, physical price of natural gas in the US? Many people say it is doing that right now, which is open to debate.
As background, the volume in UNG has gone from 1,000,000 shares a day six months ago to almost 100,000,000 a day this month – peak volume being 96 million on June 11. It has become very popular, as millions of retail and institutional investors see the current $3.75/mcf as unsustainable; it must rise to some higher level to meet the cost of production. Most research analysts say this is between $6-$8/mcf.
The only question is, how long will that take – weeks, months, or quarters.
When all that volume comes into the fund, the fund manager takes that money and issues more units of its fund to match demand so that the Net Asset Value (NAV) of the fund does not change. As volume decreases, they can redeem units.
When I called the fund Tuesday June 23, the customer service person said the fund (via its charter or bylaws) is allowed to issue up to 400 million units. At its peak on June 11, the fund had issued as many as 285 million, and had never issued more than 20 million units in a day. That day it had 258 million issued.
So theoretically, if the physical natural gas price did start to perk up, it could cause a massive trading rally in UNG, and in just a few short trading days the fund could be out of units to issue. Then we have a classic supply and demand situation where the supply runs out – no more units can be issued – and demand is steady or higher. The price of UNG must then go up, more than the price of gas or even if the natural gas price doesn’t move. Think of it as a short squeeze in reverse.
In this instance, the NAV of the fund would be greater than the natural gas price until such time the volume decreased so that the fund had less than its maximum 400 million units issued.
How likely is this? I don’t know. It would take a lot of consistent volume. But UNG does attract the volume, as everybody is seeing it as the no-brainer trade of the year, especially as the number of rigs drilling for gas has been cut in half in the last year. That will eventually start showing up in lower weekly gas injections.
The fund itself freely admits it can “lose track” with the natural gas price – see this note from its fact sheet “There is the risk that the changes in the price of UNG’s units on the NYSE Arca will not closely track the changes in the price of natural gas. If these correlations do not exist, then investors may not be able to use UNG as a cost-effective way to invest indirectly in natural gas or as a hedge against the risk of loss in natural gas-related transactions.”
To combat this from happening, the fund’s manager has asked the US regulatory body for securities, the SEC, to increase the number of shares they can issue to 1 billion, from the current 400 million. The SEC is still considering the matter. Reuters reported on June 24 that several fund managers were against the increase, as they saw it as increasing speculation in commodity markets.
The head of the CFTC (Commodity Futures and Trading Commission) in the US was on Canadian TV this week saying they are aware that several funds or ETFs were over their limit in the number of contracts they could buy (whatever that means) and they were looking into it. ( He looked very serious and I’m sure he meant every word.)
Does the ETF affect the physical natural gas price? Many people on the web say UNG is already impacting the market, by purchasing more contracts of natural gas than otherwise would ever happen, propping up current front month prices.
There is a good story on this issue from June 25: http://tinyurl.com/neayvn
I spoke to one ETF manager about this who basically said there really is no way of knowing whether natural gas would be $2/mcf if it wasn’t for the ETF buying.
I do not own UNG .
