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UNG Fires Back At Critics, Ventures Into Bilateral Nonexchange Swaps

The United States Natural Gas Fund (UNG) shot back on Friday at those who claim the fund has contributed to dramatic swings in U.S. natural gas prices since September 2007. In the process it may have fired a preemptive strike before the Commodities and Futures Trading Commission (CFTC) convenes next week to discuss possible limits on futures positions (see related story; see NGI, July 13a). The fund also took a preventive measure in case the CFTC comes down hard on noncommercial traders. The fund purchased its first ever bilateral, nonexchange traded natural gas swap contract on Friday.

In an 8-K filing made with the Securities and Exchange Commission (SEC) Friday by Howard Mah, CFO of UNG's general partner, UNG states that its "management strongly believes that the activities of UNG have not caused the extreme swings in the price of natural gas as alleged in some published articles during the above noted time frame."

"Many of the articles published on this topic have stated that UNG's large size, and the fact that it was the first publicly offered, exchange traded vehicle that offered exposure to natural gas futures, made it a key factor in the rapid rise of natural gas prices in 2008," the fund said in its filing. "Furthermore, several articles continue to make such claims for market activity continuing into 2009. However, the management of UNG believes that readily available information from UNG's website and other widely available financial news and data sources indicate that many or most of these claims lack merit."

UNG provided the crux of its argument in the form of a graph, where the fund plots the spot month natural gas futures price against UNG's total contract holdings, from the inception of the fund in April 2007 through June 30, 2009.

"The data shows that during the run-up in natural gas prices during the time period of September 2007 and $5.50/MMBtu, to July 2008, and roughly $13.50/MMBtu, UNG's holdings in natural gas futures contracts were essentially flat," the fund contends. "UNG owned 8,093 contracts on Sept. 7, 2007. The fund owned 8,587 contracts on July 3, 2008. UNG's management does not believe that this data supports the notion that UNG's investing activities could have been a driving force behind the increase in natural gas prices over this time period."

The fund further defended its impact on the markets thus far in 2009, during which time UNG has grown in size more than eleven-fold, from 29.9 million limited partner units outstanding at the beginning of January to its current size of 347.4 million units. "More recently, UNG has seen a large increase in the number of natural gas contracts owned by it. However, this increase occurred in 2009 during a period of time in which natural gas prices have trended lower, not higher," it noted. "UNG's management believes the data...does not support the theory that UNG's purchasing of natural gas futures contracts has driven prices significantly higher because natural gas prices did not rise significantly higher during the same time period."

That is in direct contrast to the conclusion reached by Raymond James & Associates in a recent note to clients (see related story). In the report, a team of analysts led by John Freeman said, "to us, it appears that the UNG has been a large driver of gas prices for the past few months. As money has flowed in, the fund's purchases of gas contracts has put strong upward pressure on gas prices. At some points, gas was trading more on the technicals of the UNG instead of the technicals of gas itself," the analysts noted. "For example, on Thursday, June 4, the EIA [Energy Information Administration] issued one of the most bearish [storage] data points of the year -- an injection of 124 Bcf, well above the consensus estimate of 117 Bcf. Gas prices immediately fell 6% on the news, causing the UNG to tumble to its previous low of $13.40, a key support level, which set off a massive spike in volume and feverish buying. Gas ended the day up 1% after rallying over 9% off its intraday lows, and the UNG traded a new record 72 million shares. To put this in perspective, in March the UNG had average volume of 4 million shares/day. By mid-June, it was up to 60-plus million shares/day."

UNG on Friday also took steps toward preparing for what may be a new regulatory world for noncommercial futures participants by purchasing its first ever bilateral, nonexchange traded natural gas swap contract. The contract has a notional value of $250 million. UNG simultaneously sold 26,950 September IntercontinentalExchange (ICE) swap contracts, a move that analysts deemed to be a precursor to possible lower limits the CFTC may impose on ICE positions.

UNG had only held exchange traded futures and swap contracts since the advent of the fund in April 2007, but the fund reserved the right to venture into other nontraded natural gas prospects in its initial prospectus filing.

The fund will now face something it has managed to avoid since its inception: counterparty credit risk. Bilateral swap contracts "are really nothing more than a series of contractual payments between parties, usually fixed for floating, and those payments are backed by the credit ratings of the particular parties," a trader with RBS Capital in Greenwich, CT, told NGI.

The counterparty credit risk UNG faces for the $250 million contract it purchased on Friday is likely relatively low, since the fund specifically stated on its website that its nonexchange traded swap is a "fully collateralized total return swap with investment grade counterparty(ies)." But the more off exchange swap contracts UNG purchases, the more a potential downgrade in the credit ratings of one or more of its swap counterparties may negatively impact the net asset value of its holdings.

UNG currently holds 22,151 September New York Mercantile Exchange (Nymex) contracts, or 13% of the total open interest for the month. UNG held as many as 27,203 spot month contracts in July, before the fund ran out of new units to issue, which in turn cut off UNG's access to fresh capital (see NGI, July 13b). UNG's assets under management swelled from $2.3 billion at the beginning of June to $4.6 billion in mid-July, and some market observers expressed concerns that the fund's extra clout could have impacted UNG's roll into the September contract. However, several analysts and traders noted the August-September roll was largely a non-event.

The ultimate arbiter of the debate surrounding UNG's impact on natural gas prices will likely be the CFTC, which is scheduled to begin a series of meetings on whether to curb speculative trading positions "on all commodities of finite supply, in particular energy commodities" on July 28. A key issue will be whether the CFTC deems trading activities of index funds like UNG to be speculative.

Given the start of those meetings, the timing of UNG's 8-K filing on Friday was likely "a deliberate move on the fund's part," a New York trader told NGI. The trader also noted that the filing could double as an attempt to convince the SEC to approve UNG's recent request to increase its share count by 1 billion units, which would more than double the 347.4 million units the fund currently has outstanding. The SEC has given no indication of if and when it will approve UNG's request.

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