The U.S. Natural Gas Fund (UNG) has learned a lot about the difficulties that come with great success over the last several weeks. The fund attracted inflows of more than $1.2 billion in July and has increased about sixfold so far in 2009, despite the fact that natural gas reserves have skyrocketed, sending prices plummeting. After issuing all of its permitted units, UNG petitioned the SEC for permission to issue an additional 1 billion units (a significant increase over the 200 million for which it had already received approval). The SEC initially delayed making a decision on the request, perhaps since the Commodity Futures Trading Commission had been planning hearings to determine whether trading limits should be imposed on speculative energy traders.
The concern has been that as UNG has swelled in size, it has gained significant influence over the prices of commodity futures contracts. Since UNG invests in near-month futures, as the expiration of the contracts approaches, it must roll over its holdings to second month contracts. This theoretically props up demand for second month contracts while driving down the price of near month futures.
Green Light (Sort Of…)
The Wall Street Journal’s Christine Buurma reports that the SEC has given its approval for UNG to issue more shares, but that the fund is sitting on its hands for now as it awaits a decision from the CFTC. “We just don’t feel it’s prudent to accept [new unit] creations and then attempt to use the money to purchase more natural-gas products when we have a strong belief that the CFTC is going to mandate limits that would either cap us or force us to reduce our holdings,” said John Hyland, UNG’s chief investment officer, according to the Journal article.
An Arbitrage Opportunity?
The inability of U.S. Commodity Funds to issue new shares has resulted in the ETF acting more like a closed-end fund, trading at a material premium to its net asset value in recent weeks. Under the relatively simple surface of exchange-traded products is a rather complex creation and redemption process that typically forces the market prices of such securities to stay closely aligned with the value of their underlying assets. But demand for shares of UNG has continued to rise as the issuer has been unable to create additional shares, resulting in a trading price well above the underlying value. Recently, UNG traded at a premium of about 3%, a staggering figure for an ETF.
The CFTC held hearings last week in Washington to determine if caps are needed to moderate the impact of speculative behavior on commodity prices. As it waits for the decision, UNG has pursued alternative ways to grow its fund without purchasing additional futures contracts. Last month, UNG bought a $250 million over-the-counter swap. Swaps are a bet between two parties on the direction of natural gas price movements.
A decision should be made shortly, although all indications are that limit restrictions are inevitable. The impact on UNG and similar exchange-traded products that invest in futures contracts remains to be seen.
Disclosure: No positions at time of writing.