Following a meeting with the chief investment officer for the United States Natural Gas Fund LP (UNG), a team of analysts with Citi Investment Research & Analysis said due to the fund's rapid growth and significant size, it could be "propping up" front month natural gas prices at the indirect expense of the back end of the natural gas 12-month strip.
After recently meeting with John Hyland, CIO of US Commodity Funds LLC (USCF), which is the general partner for the UNG, the Citi analysts led by Brian Chin noted that the natural gas futures market's recent reaction -- or lack thereof -- to current fundamentals could be due to the fund's influence.
"Despite extraordinarily negative fundamental indicators, such as the weekly storage injection numbers, natural gas prices have remained somewhat strong relative to historical price points vis a vis supply/demand figures," Chin said. "More importantly, they have not decreased to a point in our view that would provide incentives to producers to substantially restrict current production to a level that matches the glut of supply."
Created in 2007, UNG was established to provide a return commensurate with the return of the front month natural gas futures contract traded on the New York Mercantile Exchange (Nymex). Chin said while it is impossible to determine a breakdown of who is investing in the fund, he believes it is largely institutional investors.
Questions surrounding the fund's operation and its potential impact on the natural gas market have grown to a fever pitch over the last two months (see NGI, June 22). In a recent filing with the Commodity Futures Trading Commission (CFTC), USCF said that since UNG is a passively managed commodity index fund with a "neutral" investment strategy, the commission should free it and other exchange-traded commodity index funds from position limits and grant them "no-action" status with respect to their activities (see related story).
Chin's team said it believes investors focused on long-term fundamentals that could be materially better than the near term might be investing in UNG, which props up the front month. "We suspect institutional investors may be using UNG as a vehicle to gain direct exposure to natural gas prices, without the hassle of rolling forward contract positions at the end of each month," he said. "The recent upswing in capital markets and a regaining of risk appetite since March 2009 may have contributed to an influx of assets under management for UNG."
As to just how big UNG is compared to the natural gas market, the analysts said net assets at UNG have increased from $1 billion in March to $4 billion in June. "This is a significant spike in incoming fund flows, which are used to buy front-month natural gas futures. We estimate UNG now accounts for roughly one-quarter to one-third of Nymex and ICE open interest natural gas contracts," Chin said. Moreover, Chin said UNG has steadily comprised a greater proportion of Nymex open front-month and front-month plus 1 contracts.
When queried by the analysts, Hyland said he generally believes that the fund has very little impact on the natural gas futures market based on past correlations of buying data and natural gas prices. He indicated that UNG's fund flow patterns have not always correlated with changes in front-month natural gas prices during the course of its short life. Indeed, his fund data suggests opposite correlation may be occurring, the analysts said. He also indicated that incremental creation of exchange-traded fund shares might have allowed more liquidity into the market, allowing for more selling opportunities to arise in his view that might not have otherwise appeared.
As for the analysts' view that the net incoming UNG fund flows were adding net buying pressure to natural gas prices in aggregate, which likely had a positive influence on gas prices, Hyland did not refute the argument and stated it was difficult to prove or disprove.
"Given a limited set of data and his comments, we are not at the moment able to fully support our view that incoming fund flows directly prop up the front month futures contract," the analysts admitted. "As UNG grows, we hypothesize it should gain a larger and larger influence on natural gas prices. It is possible that prior correlations did not work because the fund was simply not large enough to affect natural gas prices. With a fourfold increase, a critical mass point may have been passed in our view."
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