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UNG Gets SEC Green Light to Expand, But Will Refrain

The United States Natural Gas Fund (UNG) won its two-month battle to issue a substantial number of new shares, but in the end it may not matter. The fund said last Wednesday that the Securities & Exchange Commission (SEC) will grant its June 5 request to issue up to one billion new limited partnership units, but because of recent regulatory changes in the energy derivatives markets, UNG "will not resume issuing units and offering Creation Baskets to its Authorized Purchasers at this time."

UNG also said its decision to suspend issuing new units may be more than temporary, especially if the fund would be "required to reduce or liquidate its current level of holdings in investments, or may become subject to restrictions on the types and level of investments that it may make in the future."

The approval from the SEC is a Pyrrhic victory for the fund, which was hoping to build on the investor momentum it gained in the first half of this year. UNG's outstanding unit count grew from just 29.9 million on Dec. 31, 2008 to 347.7 million units on July 8, the day the fund exhausted its previous available supply. That represents a monthly growth rate of roughly 40% during that time.

UNG charges investors a management fee of up to 0.60% for its assets under management, so the fund certainly has the incentive to issue additional units. However, in an 8-K filing the fund made with the SEC on Wednesday, CFO Howard Mah noted that UNG has elected "to suspend offerings of Creation Baskets since it could not invest the proceeds from such offerings in investments that would permit it to meet its investment objective due to current and anticipated new regulatory restrictions and limitations that have been and may be imposed by the Commodity Futures Trading Commission, the New York Mercantile Exchange (Nymex), and the IntercontinentalExchange Inc. (ICE)."

Earlier this month the Commodity Futures Trading Commission (CFTC) struck two potential blows against UNG: its decision that the LD1 Henry Hub natural gas contract offered by ICE performs "a significant price discovery function," and is therefore subject to CFTC regulatory and reporting requirements, and its declaration that some kind of speculative position limits are in order for exchange traded energy derivative contracts. (see NGI, Aug. 10a; Aug. 3a; Aug. 3b). The CFTC is expected to determine exactly what those limits will be at some point this fall.

The fund also noted in the filing that it may be hurt by "the forced use of clearinghouse mechanisms for all over-the-counter transactions." UNG moved part of its position in September ICE swap contracts into a bilateral over-the-counter natural gas swap on July 24 (see NGI, July 27), and stated in the 8-K filing that it "is in the process of entering into additional, over the counter swap contracts, which are intended to provide the economic equivalent of the return from ownership of the futures contract on natural gas as traded on the Nymex.with counterparties that would provide UNG with means to meet its investment objective."

But the filing continued that "due, in part, to the anticipated imposition of regulatory restrictions and limitations, UNG is likely to invest in futures contracts other than the benchmark futures contract and other natural gas-related investments that may have the effect of increasing transaction-related expenses and result in increased tracking error."

Some of those unrelated to natural gas investment alternatives that could lead to tracking error are futures contracts in crude oil, heating oil, gasoline, and other petroleum-based fuels traded on both U.S. and non-U.S. exchanges.

In addition, UNG declared it may elect to hold greater amounts of cash in the future, and may even possibly distribute cash back to its unitholders at some point. However, one New York analyst said cash distributions would be a last resort for the fund. "Giving back cash would likely hurt UNG in two ways. One, it would add to tracking error, and two, it would signal that the fund didn't think it could replicate changes in the natural gas prices, which is the reason people invest in the fund in the first place. So giving back cash to unitholders may result in an even bigger withdrawal of cash from the fund itself," he told NGI.

Meanwhile, the share count of the Barclays iPath Dow Jones-UBS Natural Gas Subindex Total Return exchange traded note (GAZ) continues to grow. Barclays issued another 900,000 shares in the last week, bringing the current outstanding GAZ share count to 8.9 million. Although the bank has another 1.1 million shares of GAZ it can issue under its current authorization, it is still far too early to tell whether GAZ may become a viable alternative for UNG (see NGI, Aug. 10b), in case UNG remains a closed fund. Barclays' willingness and ability to issue new GAZ shares will likely be driven by its ability to hedge its own risk, which in turn will likely depend on swap dealers continuing to be exempt from speculative position limits. The CFTC is also expected to rule on that this fall.

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