Less than one month after it stopped issuing new units to the investment public, the United States Natural Gas Fund (UNG) did an about face earlier this month and declared it may indeed resume selling "a limited" number of new units starting Sept. 28. But while those additional units will certainly help satisfy the recent swell in demand for UNG, any and all new units will be predicated on a series of restrictive conditions "that will likely keep overall unit count in UNG in check for the foreseeable future," an analyst told NGI.

UNG has traded at a premium to its net asset value ever since it put the lid on new units on Aug. 12. That premium rose to a staggering 19% on Aug. 28 before nudging back to 16.1% at the market's close on Sept. 11.

Many news sources have been pointing to that premium as the main reason that UNG may resume issuing its limited partnership units, but the main motivation may in fact lie in an 8-K filing the fund issued with the Securities and Exchange Commission (SEC) on Sept. 11. In that filing, the fund lists a number of conditions that must be met before it would issue new units, the first of which is that "UNG may, at its sole discretion, condition its acceptance of an Authorized Purchaser's offer to purchase a Creation Basket on the Authorized Purchaser agreeing to sell to UNG specified investments that meet UNG's investment objective. These specified investments will include, among other potential investment transactions, the arrangement of an over-the-counter swap contract between UNG and the Authorized Purchaser."

In other words, "you agree to sell us a natural gas swap, and we'll let you have more units," the New York-based analyst told NGI.

UNG has made no secret of its desire to transition away from exchange traded contracts in favor of less regulated over-the-counter (OTC) derivative instruments. The fund cited current and expected speculative position limits on both the New York Mercantile Exchange and the IntercontinentalExchange as the main reason it stopped issuing shares last month (see NGI, Aug. 17).

To that end, the fund has purchased two separate OTC swap contracts over the last month that currently carry the estimated notional value equivalent of roughly 14,500 October futures contacts, and the Sept. 11 announcement would give the fund the wherewithal to acquire even more. But an analyst suggested that it may also indicate the fund is having difficulty finding suitable counterparties from which to buy more of those swaps. "According to the latest Commitment of Traders report, there were only 21 swap dealers who were long future contracts. If all of them aren't up to UNG's credit standards, then that limits the available market even more," the analyst explained. "However, all of the authorized purchasers of UNG units no doubt have already received credit approval from UNG, so they make for a ready, captive market."

There are currently seven different authorized purchasers for UNG units, according to the latest UNG prospectus, but the fund does not list them by name.

The analyst believes those purchasers may be more willing than usual to sell those swaps to UNG, especially if they choose to hold the new units for their own accounts. "If natural gas prices rise, they would lose out on the swaps but gain on the units of UNG, although it wouldn't be a perfect hedge, because UNG prices don't necessarily move in lockstep with natural gas prices," he said.

UNG stated it will also reserve the right to limit the number of units it issues to a particular authorized purchaser, to vary the terms and conditions of the investment to be delivered or arranged by an authorized purchaser in order to purchase new units, and to only offer new units on particular days.

So the big question now is: if UNG does issue more units, how many more might it ultimately decide to sell? On Aug. 12 the fund received regulatory approval by the SEC to issue up to 1 billion additional units, but another New York analyst "seriously doubt(s) we'll see the mega-growth in units we saw earlier this year." UNG's unit count grew from just 29.9 million units at the end of 2008 to a recent count of 347.4 million.

The analyst believes future growth in the UNG unit count will depend on two main factors: the evolving regulatory environment, and how much of its existing exchange traded holdings UNG chooses to convert into OTC swap contracts. "The fund may just keep its moratorium on new shares indefinitely, especially if the regulatory environment appears to be getting even harsher. But more likely, UNG will buy a few more swap contracts. UNG really doesn't need that much new capital to buy swaps, since it can just liquidate its current exchange traded holdings to do that. So I don't expect the unit count to rise by all that much," he explained.

Some rumors swirling around the trading community hypothesized that UNG's announcement that it would begin to sell more units later this month caused a short squeeze in the natural gas futures market, but not all traders were convinced. "I think it is hard to believe that UNG's action alone could be behind [the recent] rally," said a New York broker. "Sure, they could be playing a part, but I don't think they are that big of a factor. The UNG fund is long only, so just because they are adding a few long contracts isn't going to cause what we're seeing. This is short-covering...and UNG isn't short."

Gene McGillian, a broker at Tradition Energy, noted that UNG's roll from long October positions to long November positions helped increase the recent volatility. The four-day roll ended Thursday, Sept. 17. "There has been a lot of anxiety in the market because of the big UNG roll that was going on," McGillian said. "With that over now, I think people...will get a better feeling about what the pressures were that brought the market from $2.400 to $3.900. These guys were long and they put pressure on the market because everyone knows that they have to roll this big position. That is why we have all of this volatility."

McGillian noted that UNG erased approximately 15,000 Nymex-sized contracts from their position during this roll, which he believes was the fund trying to keep the dollar value of their outstanding positions the same against their notational asset value. "The fact is they were doing a little more selling in October than they were doing buying in November," he said.

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