As the Commodities Futures Trading Commission (CFTC) examines the possibility of imposing speculative position limits on “all commodities of finite supply,” the $4.4 billion United States Natural Gas Fund (UNG) moved to reduce its holdings of natural gas futures contracts and indicated that it may not continue to pursue its plans to expand its fund.

On Wednesday, just one day after the CFTC began holding hearings, 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 follows on the pronouncement Monday by the CFTC that the LD1 contract indeed performs “a significant price discovery function,” and is therefore subject to CFTC regulatory and reporting requirements (see Daily GPI, July 28).

But perhaps more importantly, the fund 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 from its June request with the SEC to issue up to 1 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 even none at all.

UNG already began the process of paring down its holdings of ICE swaps on Friday, 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 Daily GPI, July 27).

Expect UNG to continue rolling out of its ICE and 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 last Friday. 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.

UNG’s action was revealed on Wednesday as the CFTC moved through its second day of hearings (see related story).

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.

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