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Although concerns over the long-term impact of fracking are ever present in the natural gas marketplace, many are beginning to see the potential for the fuel to help wean America off of its foreign oil addiction. The U.S. remains in the top two for production of the fuel and has reserves that are only exceeded by five other countries. This suggests that while oil may be in increasingly short supply, natural gas has a near limitless potential to become the fuel of choice for investors and consumers alike.
Thanks to these trends, some have decided to take a closer look at putting assets to work in this interesting space with many settling in on the United States Natural Gas ETF ( UNG - ETF report ) . The fund looks to track the changes in the price of natural gas delivered at the Henry Hub, Louisiana as measured by the changes in futures prices traded on the NYMEX. The product will follow contracts that are the near month to expire unless the nearest month is within two weeks to expire. UNG is by far the most popular natural gas ETF on the market today as the fund has more than $1.2 billion in assets and average daily volume of just over 15.1 million shares. Yet, while UNG may be extremely popular, any investor who has stayed in the fund over the long term is likely to have been disappointed with its performance (see Is USCI The Best Commodity ETF?).
In year-to-date terms, UNG is down 40.4% and over the past three years the fund has lost 84.5% of its total value. While the natural gas market has been weak, prices of natural gas per thousand cubic feet have only lost about 18% in comparison on the year. The main reason for this disconnect is the market phenomenon known as contango, which can lead many investors to heavier losses than what an investment in spot prices would suggest.
Contango & ETFs
In this situation, prices for futures contracts are trading at a level of, for example, $4/mmBtu. for natural gas while the spot price is around $3.5/mmBtu. As the contract gets closer to expiration, the futures contract price converges towards the spot price, pushing the contract towards $3.5/mmBtu. At this point, an investor will roll out of a position and buy another contract, expiring in a later month in order to avoid delivery of the product in question. When investors do this in a contangoed market, the price of the futures contract will again be higher than the spot price, creating a loop of potential losses that can be built-in to the market when a particular futures contract is experiencing contango, unless of course the gains in the commodity are enough to override this structural issue (read ETFs vs. ETNs: What’s The Difference?).
While this situation is pretty much impossible to avoid when a market is in contango, there a few ways that investors can try to mitigate the issue. Chief among them is buying contracts with varying maturities and only cycling over a small portion of the basket at any one time. This avoids the issue of front-running and it helps to lessen the blow of a month that is experiencing heavy contango as well. For investors seeking to take a closer look at funds that try to implement a methodology that keeps these ideas in mind, either of these UNG alternatives could make for an interesting choice:
Unlike UNG which only holds front-month contracts, this ETF spreads its exposure across the maturity curve. In fact, the fund consists of 12 natural gas futures contracts consisting of the near month security as well as the next eleven months. This can help cut down on contango because only 1/12th of the portfolio is rolled at any one time and a month of heavy contango will only impact a small portion of the holdings. Thanks to this focus, UNL has lost 34.7% so far in 2011 and 53.6% over the past three years. While these are obviously both pretty bad metrics, they are quite impressive when compared to UNG, showing how powerful the impact of contango can be on a portfolio of commodity securities (see Three Best Gold ETFs).
For investors seeking a new way to play the natural gas market, NAGS could be an interesting choice. The product invests in futures contracts in the nearest to spot month for the following four periods; March, April, October, and November. All four months are weighted equally giving the fund balanced exposure across these key delivery dates. These four were chosen in particular because they give the fund a focus on the key times in the natural gas season at both the end of and beginning of the heating and cooling seasons.
This method has had a spotty trading performance since its launch earlier in the year as the product has underperformed since inception, but it has outperformed its counterparts over the past three months. Nonetheless, it is important to remember that all three products track the same futures; the only difference is the date until expiration for the contracts in the portfolio and the weights given to these securities. Given how drastically different products have performed tracking the same futures in different ways, investors should realize how important the issue of contango can be in a futures-based investment. Arguably, an investor’s thoughts on the subject of the futures curve can be just as important, if not more so, than a view on the underlying commodity, making products like NAGS and UNL intriguing choices when the futures curve is experiencing heavy contango in the natural gas space (see Top Three Precious Metal Mining ETFs).
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