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GAZ Picking Up Some of the UNG Slack, At Least For Now

The United States Natural Gas Fund (UNG) may have no more limited partnership units left it can sell, but that has not entirely prevented the flow of new money into exchange traded securities that mimic the movements of natural gas prices at the Henry Hub.

While the outstanding unit count of UNG has been stuck at 347.4 million units since the fund last issued units to the public on July 7 (see NGI, July 13), the share count of Barclays iPath Dow Jones-UBS Natural Gas Subindex Total Return exchange traded note (ETN) has grown nearly 20% since that time. The Barclays iPath Natural Gas ETN -- which trades on the New York Stock Exchange's Arca exchange under the ticker "GAZ" and tracks changes in the spot month New York Mercantile Exchange (Nymex) natural gas futures contract -- has grown from a share count of 6.76 million on July 8 to 8.02 million as of the close of trading on Aug. 3.

But while that growth may be noteworthy, an analyst was quick to observe that the GAZ fund likely is having little impact on natural gas futures prices, since "GAZ pales in comparison to the billions currently under management at UNG." As of the close of trading on August 3, GAZ had a market capitalization of just $136 million, 35 times less than the $4.8 billion UNG fund.

Exchange traded notes were first established by Barclays Bank plc in 2006. ETNs trade like shares of stock, but are actually uncollateralized debt securities issued by an underlying bank. Each of the underlying securities in the GAZ exchange trade note was issued by Barclays in $50 denominations, but the principal amount is adjusted to reflect changes in natural gas prices, as measured by the Dow Jones-UBS Natural Gas Subindex. Although the notes do not mature until 2037, investors may sell the publicly traded shares of GAZ at any time, just as they can with the limited partnership units of UNG. GAZ notes do not pay any interest, so the rate of return is driven mainly by changes in principle value, which in turn is linked to changes in the Henry Hub natural gas price.

As debt securities, shares of GAZ carry a degree of credit risk. However, even after acquiring troubled Lehman Brothers in 2008, Barclays currently has a Standard & Poor's debt rating of "AA-", well above the "BBB-" minimum rating needed to be considered investment grade. UNG also will carry a certain degree of credit risk going forward, now that the fund is venturing into more nonexchange traded financial instruments (see NGI, Aug. 3a).

Perhaps the biggest difference between UNG and GAZ is that unlike UNG, GAZ does not hold any actual futures contracts on behalf of its investors. As a result, GAZ is not considered a commodity pool, and is therefore not regulated by the Commodities Futures Trading Commission (CFTC). That means GAZ does not have to seek the CFTC's blessing before issuing new shares, a problem that is currently holding up UNG's request to issue one billion new limited partnership units. UNG has also stated it may not issue any new units even if it is granted that request.

If UNG were no longer able or willing to issue new shares, GAZ would have an opportunity to absorb some of the incremental demand of would be natural gas investors, at least in theory. But Barclays would likely have to grow the number of outstanding GAZ shares substantially to do so, and there is no telling when or even if the GAZ share count may ever rise above its current 10 million limit. Barclays authorized five million shares when it launched GAZ in October 2007, and followed that with another five million share authorization on June 15. A Barclays company representative would neither comment on the bank's policies for issuing new shares, nor on its plans for doing so in the future.

Barclays has a total of 19 different exchange traded notes, the largest of which is the iPath Dow Jones-UBS Commodity Index Total Return ETN, with a current market capitalization of $1.4 billion. Even if Barclays were willing to issue enough new shares of GAZ to reach that market capitalization, the fund would still be a third of the size of UNG.

A New York sell-side equity research analyst who covers the financial institutions industry speculated that if Barclays were to issue a substantial number of additional ETN shares, it would likely do so only if the bank were able to hedge its risk. "Banks simply aren't taking the kind of risks today that they were before the financial meltdown. Those [GAZ] notes probably don't make up for a whole lot of Barclay's total debt, but I'm guessing they'd want most if not all of that stuff to be hedged," he told NGI.

The Barclays representative also declined to comment on the bank's hedging practices, but the company does mention in its iPath ETN prospectus that "we or one of our affiliates may hedge our obligations.by purchasing index components (including the underlying physical commodities), futures or options on index components or indices, or other derivative instruments with returns linked to the performance of index components of indices." In the case of the GAZ shares, that index is tied to the spot month Nymex Henry Hub natural gas futures contract. Barclays would likely only able to hedge for as far out as there are liquid forward natural gas price curves, but the firm could roll over its hedges throughout the remaining term on the 30-year notes.

A key determinant in Barclays' ability to hedge its natural gas exposure under its GAZ related debt -- and therefore its potential for issuing new shares of the GAZ exchange traded notes -- is whether swap dealers will continue to be exempt from the number of futures contracts it can hold. The CFTC appears resolved to implement some kind of speculative position limits in the energy markets, but it has yet to determine whether the current futures position exemption for swaps dealers should be continued (see related stories). CFTC Chairman Gary Gensler indicated the agency may not establish any formal policy on this issue until later this fall (see NGI, Aug. 3b).

One theoretically favorable scenario for GAZ would be if legislators rule to limit holdings in over-the-counter derivatives by index funds, as is currently being discussed in the U.S. House of Representatives (see NGI, Aug. 3c), but continue to offer a bona-fide hedging exemption on futures positions for swaps dealers. In this case, "UNG would be limited in the number of swap contracts it could hold on behalf of its investors," the New York equity analyst told NGI. However, "GAZ would likely still be able to use the OTC swaps as a hedge against higher future debt payment requirements. If swap dealers were not limited into how much counter risk it could hedge in the futures market, then there in turn would be little to no limitation on how many swaps those dealers could issue."

The net result would be if Barclays were free to hedge its debt that is tied to changes in natural gas prices at will, then the bank would be much more likely to issue additional GAZ shares, the analyst reasoned.

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