Yielding to pressures from the Commodity Futures Trading Commission (CFTC), the $4.4 billion United States Natural Gas Fund (UNG) announced last Wednesday it would reduce its holdings of natural gas futures contracts, and said it may not pursue its plans to expand.

Just one day after the CFTC began holding hearings on imposing speculative position limits on "all commodities of finite supply" (see related story), UNG formally announced through an 8-K filing with the Securities and Exchange Commission (SEC) that it will actively seek to reduce its holdings of the IntercontinentalExchange (ICE) Henry Financial LD1 Fixed Price Contract.

This also followed on Monday's announcement by the CFTC that the LD1 contract, dubbed the "Henry Hub Look-alike," indeed performs "a significant price discovery function," and is therefore subject to CFTC regulatory and reporting requirements.

It wasn't a good week for Wall Street. Rounding out the Washington activity on speculative trading two powerful House committee leaders got together on a "concept" paper for legislation to limit speculative commodities trading (see another related story).

And at the end of the week Sempra Energy executives weighed in with the observation that the activity around speculative trading was not likely to harm commercial traders. "The push from the commodity traders, such as us [RBS Sempra Commodities joint venture], is that there is a recognition that these markets were effectively established for end-users -- producers, power plants and those kinds of companies who use these markets to hedge their outputs or their raw materials. From that perspective, I think those businesses will get some kind of exemption from the margining requirements so they can continue to do that. And that is really what is core to our business." (and another related story).

UNG also announced that it may no longer be willing to issue any new units, or creation baskets, even if it is approved to do so by the SEC. "Due to the very recent changes introduced by ICE and the CFTC, management cannot determine at this time if, in the event that the registration statement was declared effective immediately, UNG could in fact permit the normal creation process to commence again." UNG is still awaiting approval on its June request with the SEC to issue up to one billion additional units, but even if its application is approved, it noted that it may still choose to issue just a portion of that new allotment, or none at all.

UNG already began the process of paring down its holdings of ICE swaps on June 24, when the fund sold 26,950 September ICE swap contracts and purchased a $250 million, bilateral total return natural gas swap with a series of investment-grade counterparties (see NGI, July 27).

Traders expected UNG to continue rolling out of its ICE and New York Mercantile Exchange (Nymex) positions in the days ahead. "The Nymex [natural gas] futures contracts and the LD1 contract, the economic equivalent of UNG's benchmark futures contract, have to date provided the best means for UNG to meet its investment objective of tracking percentage changes in the price of the benchmark futures contract," the fund noted in the 8K filing. "However, UNG has been forced to consider other investment alternatives in order to avoid violating these new limits and to avoid regulatory action."

Those other investment alternatives include over-the-counter natural gas swaps, such as the one the fund purchased June 24. However, UNG also warned that it "may invest in other investments that provide a return that differs from that of owning the benchmark futures contract and this may adversely affect UNG's ability to meet its investment objective."

An analyst told NGI that it is possible UNG could invest in U.S. exchange-traded commodities that do not correlate perfectly with the Henry Hub natural gas contract, such as crude oil, or it could seek to purchase futures contracts that are not traded in the U.S. That could introduce a certain degree of tracking error between UNG's stated goal of having percentage changes in its net asset value mimic changes in its Benchmark Futures Contract, which is the prompt-month Nymex Henry Hub contract, except during the monthly roll period, when the benchmark is a combination of the first two listed Nymex contracts.

To date, UNG has experienced very little tracking error, usually by no more than a basis point or two (one or two hundredths of a percentage point), the analyst noted. However, according to its prospectus, UNG allows for a permissible tracking error of plus-or-minus 10%, so it is conceivable that the fund could invest in a variety of different financial instruments that do not correlated perfectly with changes in U.S. natural gas prices, and still be in compliance with its stated goal.

The analyst further stated that greater tracking error could scare off potential future new investors in the fund, but that may not be an issue if UNG fails to create any more new units.

Some traders were concerned that UNG's imminent exodus from prompt month's contracts could have an impact on futures prices, but other said they didn't expect the fund to dump its holdings all at once, and the market should be able to absorb the activity. Others were considering whether the CFTC's drive to limit speculative trading would lower natural gas futures prices if investment or "speculative" traders were limited (see related story).

Some argue that index funds and exchange-traded funds are passive investors and as such have no impact on the market. Others see it differently.

In the CFTC hearings last week commissioners closely questioned veteran trader and market commentator John J. Lothian, who said passive traders in the commodities markets such as index funds and exchange-traded funds "have become such large dominant players that they are the fundamentals in the marketplace." Instead of watching supply-demand factors for the actual commodity, traders are watching for the role of the index funds "because that's the dominant theme in the marketplace, as opposed to, perhaps, cash-futures convergence. That element of it can get overwhelmed," he said.

Lothian cited an incident in the wheat market several years ago when prices spiked. "Part of the problem was that the pit traders were all situated one way in the market to take advantage of the roll [of the investment funds]. When Australia said, 'Hey, we have some problems with our crop' and then other problems cropped up around the world, all of a sudden the nearby prices shot up, and the wheat traders lost not only what they made that year, but what they made [in the] previous year as well."

Lothian, who publishes the widely read John Lothian Newsletter, said the tremendous exposure of commodities to the large index fund investments "has changed the behavioral aspects of some of those commodities because such a large dominant player is not acting by the rules of the market that I grew up with." When the market goes up the traditional behavior is for traders to sell and take a profit. With index investors the reaction is to invest more money.

"The aggregate demand approach to commodities as an asset class, I believe, has changed some of the dynamics of some of the markets and the markets are adapting to that, but it becomes critical when you get into the delivery period." Putting investment money into cash-settled, rather than physically settled contracts, avoids interfering with the delivery process, he said.

Among the energy commodities, natural gas is one that would be more easily controlled by the CFTC since the market is mainly North America; it is not a large global market like crude oil or wheat.

The CFTC's recent action bringing the ICE Henry Hub contract under its purview was not unexpected. The agency had said in June it would look at the status of the ICE exchange-traded swap since it appeared to fit the criteria of a new rule issued earlier this year calling for closer oversight of contracts with a significant amount of trading that perform a price discovery function (see NGI, June 22).

And, in fact, the CFTC determined that it did "perform a significant price discovery function," similar to that of the CME Group's Nymex Henry Hub contracts, which already comes under CFTC regulation.

"To protect the American public, it is essential that we bring transparency and accountability to the marketplace," CFTC Chairman Gary Gensler said. "Bringing this natural gas contract under the CFTC's regulatory authority is a critical step toward ensuring a fair and orderly marketplace. We will continue to use this authority and our other existing authorities, as well as work with Congress to secure additional authorities, to police energy markets for fraud, manipulation and other abuses."

ICE followed up with a press statement last Monday, which stated it would begin submitting enhanced market statistics for its cash-settled Henry Hub natural gas swap market to the CFTC immediately. Clearing firms will begin providing large trader data to the CFTC and ICE's data will be incorporated in the weekly Commitment of Traders (COT) report. In addition to its inclusion in the COT report, the ICE Henry Hub swap will also be subject to position limits and accountability levels.

The company said it has worked with the CFTC in developing regular over-the-counter market reporting, including large trader information, since October 2006.

The order was effective immediately, although ICE will have a grace period of 90 days from the date of the order in which to submit to the commission a written demonstration of compliance with the core principles. A spokesperson said ICE eventually would be posting some aggregate open interest data on its website, but they was unsure when that would occur.

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