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Natural Gas ETFs: Futures vs. Equities

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The weak macro economic situation across the globe has had significant impact on investors worldwide. Over the past six months, we have witnessed a sharp increase in volatility across all asset classes.

However, the near future doesn’t look very optimistic either. Especially if the slippery situation across both sides of the Atlantic worsens or even remains the same (read Three Defensive ETFs for a Bear Market).

Commodities so far have had a dismal year as well. Many of the finished goods export oriented economies such as China, Hong Kong, and South Korea have witnessed a considerable decrease in their industrial production (read Top Commodity ETFs in This Uncertain Market). This is mainly due to reduced import demand from their trade partners, especially the debt plagued Euro zone nations, and to a lesser extent, America too.

This trend, along with a strong dollar, has pushed commodity prices lower with many key global resources remaining under pressure for the year.

Closer to home, investors have seen a similar situation in the natural gas market as well, as the commodity remains well below its highs. New technological processes, such as better drilling techniques, are being implemented and have caused the supply of the potent fuel to surge.

This sharp increase in supply has coupled with weakness in the demand picture in recent months to lead to a truly bearish situation for the natural gas market (see Beat the Heat with These Three ETFs).

All these instances taken together have accounted for an oversupply situation in the market and have resulted in falling natural gas prices since the highs of 2008. However, with summer setting in, the demand for the commodity is finally witnessing an uptrend as natural gas is also used for cooling requirements in air-conditioners.

Also, industrial consumption is witnessing a surge as power plants use natural gas instead of crude oil, to generate electricity. This trend is also expected to remain for quite some time, given the fact that crude oil prices are substantially higher than natural gas prices (on a comparative output basis), and since natural gas is more environmentally-friendly than coal (see Two Energy ETFs Holding Their Ground).

Given this shifting market outlook some investors may want to consider making a play on this beaten down market segment. Currently, there are quite a few choices for investors seeking the ETF route to gain exposure in this commodity segment. However, it is very important to note the difference between these options in order to prevent getting singed by natural gas investments.

Broadly speaking, investors can gain exposure by the Futures ETFs or the Equity ETFs that target this space. These two broad genres of ETFs differ substantially in terms of their structure, expenses, risks involved and benchmark indexes (see more in the Zacks ETF Center).

Equity natural gas ETFs basically include stocks of companies that are engaged in the production and exploration of oil and natural gas in their portfolio. Therefore, it is implied that these would not be impacted by the technicalities and complications of the derivatives market.

However, these ETFs will be exposed to the cyclicality in the commodity market. Some of these funds include First Trust ISE Revere Natural Gas ETF (FCG) and Market Vectors Unconventional Oil & Gas ETF (FRAK)

The First Trust ISE Revere Natural Gas ETF (FCG) is a natural gas equity ETF. It employs a rather innovative methodology to select stocks from the entire universe of companies engaged in the energy exploration business. The stocks are screened and ranked based on certain fundamental factors such as price to earnings, price to book value, market capitalization and return on equity.

The ranks are then averaged and the top 30 stocks become part of the index and are weighted equally. However, it is prudent to note that these stocks do have the strongest correlation with the natural gas futures price, therefore it may not be a pure play on the commodity.

Thanks to this unique methodology, the ETF charges a hefty premium of 60 basis points in fees and expenses. FCG was launched in May of 2007 and since then has been able to amass $438.69 million in assets under management. The ETF has an average daily volume of 554,668 shares and pays out a paltry yield of 0.50%.

Also, the Market Vectors Unconventional Oil & Gas ETF (FRAK) is another option from the natural gas equity ETF space that investors might consider investing in. Launched in February of this year, it is a relatively new ETF in this space.

The ETF is pretty similar to FCG in terms of strategy, however, it does not offer a pure play in the natural gas segment as it is exposed to companies involved in exploration instead (read Three ETFs for The Unconventional Oil Revolution).

On the other hand, Natural Gas futures ETFs are basically instruments that try to capture the daily difference in spot prices of natural gas by gaining exposure to future contracts. Although futures can be considered an efficient, cost effective way to gain exposure in the commodities market without having to deal with storage costs and physical delivery, they still have their own risks.

The United States Natural Gas ETF (UNG) and the United States 12 Month Natural Gas ETF (UNL) are some choices available in the Natural Gas Futures ETF space. The ETFs are almost same in terms of strategy and workings. UNG takes positions in the near-to-expiry natural gas futures contracts. As the contract nears maturity, the contracts are rolled over to the next month (read Buy American with these Three Commodity ETFs).

On the other hand UNL does the same thing, but it spreads out its exposure across contracts with 12 different expiries in 12 months. Both of these products charge a steep expense ratio. UNG charges 60 basis points, whereas UNL charges 75 basis points. However, UNG comfortably beats UNL in terms of total assets and daily volumes traded.

UNG has total assets worth $1.18 billion and an average daily volume of almost 10 million shares compared to UNL, whose total assets stand at $48.46 million and an average daily volume of 55,514 shares. However, both these products have seen the worst of times in the recent past thanks to the heavy ‘contango’ in the natural gas futures market.

Impact of Contango on UNG and UNL.

The strategy of UNG and UNL implies that during roll over (done in order to avoid physical delivery), the price of the far-from-expiry contract (which it buys in order to roll-over), should be lower than the price of the near-to-expiry contract, thereby booking the differential as profit.

However, if the price of the far dated contracts becomes higher that price of the near dated contract, the ETFs will book losses every time the position is rolled over. This happens in a market which is in “contango”. Contango is basically when the futures price is higher than the expected futures spot price.

A market in contango signifies that supply exceeds demand, therefore given the oversupply in natural gas and a decrease in natural gas prices, the natural gas futures market have gone into a state of contango. This is exactly the reason why these two futures ETFs have put up a dismal performance in the recent past.   

Is the trend changing?

Given the recent surge in the natural gas prices, one might think that a reversal has finally set in the natural gas market. UNG and UNL which have lost 27.2% and 19.3% respectively, on a year-to-date basis are starting to post positive returns for shorter time frames.

The three month absolute returns for UNG and UNL as on 30th June 2012 were 21.17% and 7.13% respectively. It was mainly thanks to the recovering demand due to the anticipated warm temperatures as well as more power plant usage of the fuel.

Still, for the same time period, FCG fetched negative returns of 6.86%. On a year to date basis the equity ETF has slumped 8.0% so the futures could be recovering faster than their equity counterparts (see Have the Natural Gas ETFs Finally Bottomed Out?).

While the traditional buy and hold strategy seems to fail as a strategy for futures ETFs, for the informed investors, these can be great money making avenues, especially given the recent trends. However, it should only be considered by investors with sound knowledge about the recent trends in the underlying commodity market.

On the other hand, for the average investors who wish to keep away from the subtleties in the derivative markets, equity ETFs provide a buy and hold option, especially for the long term.

This could be especially true in the natural gas market, as the products targeting this space may finally be on the upswing. Furthermore, it appears as though they take quite some time to turn around, implying that gains could still be had in the natural gas equity market should present positive trends continue.

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