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Impact of New 12-Month Natural Gas ETF Likely to Be Muted

The United States Commodity Funds LLC (USCF) completed a 28-month process last Wednesday to launch its United States 12-Month Natural Gas (UNL) exchange-traded product. Unlike its sister United States Natural Gas (UNG) fund offering, which focuses on replicating price changes of the near-month New York Mercantile Exchange (Nymex) futures contract, the UNL exchange-traded fund (ETF) is attempting to track movements in the prices of the nearest 12-month Nymex futures strip.

Although Wednesday (Nov. 18) was the first official day of trading for UNL, the fund was actually organized as a limited partnership on June 27, 2007. UNL closed its inaugural day of trading at $48.08, down 2.4% from its opening trade of $49.24 and down 3.9% from the initial $50 notional value of each unit. A total of 17,456 limited partnership units changed hands. UNL will seek to hold an equal number of futures contracts for each month in the strip, and Wednesday's $50 million cash infusion netted the fund seven or eight Nymex contracts for each of the January-through-December 2010 listings.

UNL marks the second 12-month strip product offered by USCF. The group launched its United States 12 Month Oil (USL) fund in December 2007.

The establishment of UNL will give investors not only an alternative to UNG, but also some potential relief from the value-destroying effects that the current contango market has been having on the UNG fund. During contango markets, UNG must replace its existing holdings with more expensive contracts, thereby creating a negative yield, all other things being equal.

Every month UNG rolls its futures holdings from the prompt month contract into the following month over a four-day roll period that typically starts 10-11 calendar days before the expiration of the near-month contract. UNL will also have a monthly roll, but that fund will only have to sell one-twelfth of its futures contracts each month, versus 100% for the UNG fund, thereby limiting the negative impact of any contango roll.

That is certainly a positive for UNL, given the current Nymex natural gas futures strip, but some energy buyers (and Washington, DC, regulators) are no doubt concerned about one big potential negative: Will UNL place undue influence on natural gas futures prices?

Two factors suggest the answer to that question will be no. Perhaps the most limiting influence may simply be the fund's size. The current UNL shelf registration allows the fund to issue another 29.9 million limited partnership units, in addition to the 100,000 the fund debuted on Wednesday. Per the terms in the UNL prospectus, each 100,000 block of new units, also known as a "creation basket," represents a capital contribution of $5 million to the fund. That translates into roughly $149.5 million in additional cash UNL could use to buy futures contracts.

If UNL were to use that entire $149.5 million to purchase an equal number of the January-December 2010 futures contracts at Wednesday's average $5.152 strip price for those 12 months, that would translate into roughly 242 additional contracts for each month, or 2,904 contracts in total. That is just 0.4% of the total 717,439 open interest reported on the latest Commitment of Traders report for Nymex natural gas futures contracts, a sum that is "barely enough to move the needle," a New York-based analyst told NGI.

The other dynamic that may limit UNL's impact on the futures market will be possible restraint by the fund itself. According to the UNL prospectus, "Any futures contracts held by USNG [UNG] will be aggregated with the ones held by US12NG [UNL] in determining Nymex accountability levels and position limits." So the establishment of UNL may not necessarily raise the theoretical maximum number of natural gas futures contracts that USCF may hold across all its funds per se.

"That's an important distinction to note because UNG has been de-emphasizing futures contracts lately and not really adding to them. So I doubt UNL will materially add to the number of contracts held by both UNG and UNL," the analyst said. In mid-July UNG was invested 100% in exchange-traded futures and swap contracts, but expected speculative position limits for energy futures contracts traded on Nymex and the IntercontinentalExchange (ICE) forced UNG to purchase more over-the-counter (OTC) swaps (see NGI, July 27). As of Wednesday's close, OTC swaps represented roughly 47% of UNG's $3.4 billion in total net asset value. USCF also reserves the right to purchase nonexchange traded products for UNL.

Theoretically, because UNL attempts to replicate price changes for the nearest 12-month futures strip, it should provide a much better platform to hedge one year out than the UNG contract could, the analyst said. "UNG is really unsuitable as a hedging vehicle, especially in contango markets, because of the negative roll. It also violates the basic tenet in finance of duration matching. That is, long-term assets should hedge long-term liabilities. Using a fund like UNG to hedge more than one month out is generally a bad strategy. Just ask MG [Metallgesellschaft]," he told NGI.

He was referring to MG's "stack-and-roll" strategy of 1993, when the firm racked up $1.3 billion in derivative losses by rolling over one-to-three month Nymex positions to hedge long-term delivery obligations during a steep contango market. In fact, the Harvard Business School features MG's stack-and-roll strategy in a business case as a paradigm example of how not to hedge.

But if the existing USL fund is any indication, natural gas industry participants will not likely line up to use UNL as a hedging tool anytime soon. According to Thomson Reuters, institutional investors owned 56% of the outstanding USL units as of Sept. 30, and none of those investors were associated with energy companies. Throw in myriad individual investors who no doubt hold units of the fund, and the likelihood that energy companies own any meaningful quantities of USL diminish.

"We have never considered using UNG or any of its related products for hedging purposes, and quite frankly, I don't know of any other producers who have either," a hedging representative for a Fortune 500 exploration and production company told NGI.

Part of the reason for that could simply be that the various products offered by USCF may not qualify for favorable treatment under the Financial Accounting Standard 133 hedge accounting standard. The Fortune 500 hedger noted that hedge instruments "typically need to have at least an 80% correlation as measured by the R-square statistic to the asset you are trying to hedge to be a bona fide hedging instrument. It wouldn't surprise me if UNG, USO, and the 12-month strip oil product [USL] have high correlations to the movements of their underlying natural gas and futures contracts, but those instruments can and have all traded at significant premiums to their net asset values, which could undermine the effectiveness of the hedge," he reasoned.

For example, UNG traded as high as 20% above its net asset value in late August before the announcement that the fund would resume issuing limited partnerships units again in September drove that premium significantly lower (see NGI, Sept. 21). UNG closed trading Tuesday at a 3.8% premium to its net asset value, while the competing iPath Dow Jones-UBS Natural Gas Subindex Total Return exchange traded note (GAZ) ended the Tuesday session 8.5% above the value of its natural gas benchmark.

Other potential sources of tracking error that could impact the hedging effectiveness of UNL could come from the fund holding a large portion of its assets in cash, or from different bid/ask spreads for the nearest 12 months Nymex contracts.

The hedger further noted that UNL may not qualify for hedge accounting treatment because it is an equity instrument and therefore has no expiration date. The derivative contracts that make up the fund do, but the fund itself does not.

Producers generally prefer to use hedge accounting because they can defer gains and losses until the hedges expire. If hedges do not qualify for hedge accounting treatment, the gains and losses of those instruments must be marked-to-market and booked as income or losses each quarter, and "that can really muddle things from a reporting standpoint," the hedger said.

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