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. 

(An ETF, or exchange traded fund, is a security that tracks an index but trades like a stock.)

The two charts tell us that despite all the bearish fundamentals for natural gas in North America (and there are lots!), the time to buy UNG is very near.  The chart for the Canadian natural gas ETFs (GAS-TSX, HNU-TSX) tells the same story.

In February of this year, when everyone thought oil was going to stay at $40-$45 per barrel throughout 2009, the ETF for oil in the US, USO-NYSE, bottomed.  Its downward momentum was matched almost exactly with a rising crescendo of volume from investors.  The ultimate low was still a couple weeks away, but as soon as the volume started to subside, the ETF tracked higher. 

UNG-NYSE and GAS-TSX are now showing signs of going through the same tell-tale crescendo of volume.  This would indicate that investors believe the natural gas price in North America has bottomed, or is very near bottom.