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UNG Fund Gives Investors Less 'Gas for the Buck,' Analysts Say

Speculation surrounding the United States Natural Gas Fund's (UNG) impact on the natural gas futures market has reached a fever pitch, and now some analysts are advising investors that the commodity exchange-traded fund (ETF) is not even a good investment. According to a new Raymond James & Associates report, investors are "better off" investing in gas-weighted exploration and production (E&P) companies than in UNG.

"We believe that the UNG has been propping up gas prices for the past few months, therefore delaying the inevitable forced rebalance of supply and demand," said a team of Raymond James analysts led by John Freeman. "Regardless of our outlook on gas prices -- which, to be clear, remains extremely bearish in the near term -- investors are better off investing in gas-weighted E&P companies than in the UNG," he said. "By investing in the UNG, investors have unwittingly been 'subsidizing' gas prices for E&P producers -- while hurting their own returns. While commodity ETFs like the UNG are a simple way for investors to get access to the commodity market, unfortunately the UNG has grown well beyond its critical mass. We would argue that it is no longer an efficient investment vehicle, and in fact it appears to be a distraction to the futures market."

Freeman said UNG was developed as an open-ended ETF designed to track natural gas prices in percentage terms. The fund operates by buying and selling front-month gas contracts, tracked at Henry Hub, to maintain the correct gas exposure level so that the fund moves in step with benchmark gas prices. Being open-ended, when interest in the fund grows, the fund issues more shares and purchases more gas contracts. When the fund is sold, the reverse is true, he said.

Ahead of a front-month contract's expiration, the fund has to sell its front-month contract and concurrently purchase the second-month contract, which is done over a four-day period to minimize the fund's impact on the market and to avoid allowing traders to exploit a "set" game plan. This month, UNG rolled over its long August futures contracts to long September contracts from Wednesday (July 15) to Monday (July 20), in increments of 25% over each of the four trading days.

"This four-day rollover was a noticeable improvement relative to the one-day rollover of the UNG's sister oil fund, the United States Oil Fund (USO/$34.24), which was notoriously exploited by smart oil traders," Freeman said in the report.

Since hitting the radar more than two months ago due to its rapidly increasing position levels in the natural gas futures market (see NGI, June 8; May 18), UNG has had traders and analysts alike dissecting whether the fund is keeping gas prices artificially high. In mid-May some analysts were claiming that the ETF might be cornering the market because it allegedly is holding title to as much as 80% of the June contract's open interest on the New York Mercantile Exchange (Nymex).

Late last week the Industrial Energy Consumers of America (IECA) urged the Securities Exchange Commission (SEC) not to issue additional shares to the currently tapped out UNG fund, noting that the additional shares could distort and possibly raise the price of natural gas long term for manufacturers and other consumers (see NGI, July 20). IECA's statement was issued less than a week after total units outstanding in UNG surged to a record 347.4 million as investors continued to pour money into the fund, despite the recent downturn in U.S. natural gas prices (see NGI, July 13a). Any further increases in units outstanding would have to wait until the SEC allows UNG to issue more units to the investing public. The fund recently announced that it had no more units to float under its existing shelf registration, but it was awaiting SEC approval on its June 5 application to issue up to one billion additional units, which, if granted, would give it the ability to more than double its current units outstanding.

The Commodity Futures Trading Commission (CFTC) recently revealed plans to host a series of meetings through August to determine whether it should establish speculative limits on certain commodities, including natural gas (see NGI, July 13b). In a filing with the CFTC in early June, UNG management said that as a passively managed commodity index fund with a "neutral" investment strategy, the CFTC 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 NGI, June 29).

As investors have flocked to natural gas futures to take advantage of the perceived discounted value, the UNG fund has taken off. According to the analysts, the fund has grown from one of the smallest commodity ETFs into one of the largest. Entering March the fund controlled $660 million of total net assets. It now controls more than $4 billion worth of gas; is now two times larger than the USO and is now the second largest commodity ETF behind gold. "This is especially alarming considering the USO was once considered to be manipulating the oil market, and the global oil market is far larger than the domestic natural gas market," Freeman said. At the beginning of March the fund had 39 million shares outstanding, which has jumped nearly ninefold to 347 million shares.

"To us, it appears that the UNG has been a large driver of gas prices for the past few months," Freeman said. "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. For example, on Thursday, June 4, the EIA [Energy Information Administration] issued one of the most bearish [storage] datapoints 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."

Freeman said investors get less "gas for the buck" because the fund has to sell cheaper front-month futures and buy the more expensive second-month contract with the same amount of money. "While investors see current gas prices below $4/Mcf and think prices should be at least $5/Mcf next spring, in reality the market is already pricing in an even higher price for next spring, say $5.50/Mcf," he said. "In essence, if prices rise to $5.50 next spring, the fund may not go up at all. In addition, the larger the fund becomes, the more likely smart, nimble traders will be able to trade in front of it and profit from the rollover. The larger the UNG gets, the more it will underperform physical gas futures."

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