Natural Gas ETF Implosion

By Investopedia Staff | August 27, 2009 AAA

Natural gas seems to have fallen out of favor in 2009. Over the past year the spot price of natural gas has fallen from a high of $14 to below $3. The primary reasons for the free-fall in price is the sizable natural gas inventories around the world combined with a relatively stubborn natural gas industry which refuses to slow production in the wake of a global recession and economic slowdown.

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Widening Gap
As the bifurcation between oil and natural gas began to play out this year, many looked at the widening gap in the oil to natural gas price ratio as an opportunity to long natural gas, which they thought was merely lagging the recovery in oil prices by a few weeks. As weeks turned into months, the oil to natural gas ratio has reached historic levels (over 22-times as of Tuesday). Those that bet on natural gas' recovery through the United States Natural Gas Fund ETF (NYSE: UNG) have felt the brunt of the pain; UNG is a mess. Shares are down 50% in 2009 alone, and 17% in the last 3 weeks to trade at $12, down from a high of $63.89 last summer. The fund has also, for all intents and purposes, reached its position limits set forth by the CFTC, all but deeming UNG a closed-end fund due to its inability to issue new shares. The lack of new shares has led UNG to trade at an almost unheard of premium of 11% over its NAV.

Swaps
In a desperate maneuver to create more units, UNG's managers entered into a $250 million over-the-counter swap contract in July, and recently announced that they had also entered into a $500 million natural gas total return swap. By entering into these swap contracts, UNG has added significant risk to shareholders by introducing a large amount of counterparty risk into the equation. It's a desperate move by a desperate group.

Long Road Ahead
Having performed equally as badly, the Barclays IPATH Natural Gas ETN (NYSE: GAZ) has also been a big loser of late. Down 50% YTD and 11% in the past 3 weeks, GAZ has managed to keep its premium below 9%. Also, since GAZ's holdings are quite a bit smaller than UNG, the former fund may have an easier time in reducing its premium. That being said, since both funds hold near-dated future contracts (currently September and October '09 contracts) they may be in for some hard times in the medium term as well. As the current contango in natural gas futures flattens, as evidenced by the large open interest on natural gas puts for October, natural gas prices may not recover until 2010. Even in that case, with the large reserves still remaining and the majority of natural gas producers refusing to stop production, capacity may be reached rather soon, putting greater downward pressure on natural gas prices.

Bottom Line
Right now, the outlook for natural gas and UNG along with GAZ does not look promising. I would suggest staying away from these funds for the foreseeable future and waiting to see if their managers can straighten out the mess that these funds have gotten into. (To learn more, see our Oil And Gas Industry Primer.)

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