UNG Locks Up $500 Million Natural Gas Swap

by on August 25, 2009 | ETFs Mentioned:

The United States Natural Gas Fund (UNG), its hands tied by regulations expected to be enacted by the Commodity Futures Trading Commission (CFTC) and other government agencies, is getting creative in its attempts to expand the size of its fund without increasing its exposure in listed futures contracts. UNG, which last month entered into a $250 million over-the-counter swap contract, has now secured a $500 million natural gas total return swap, according to Energy Risk.

“This is an attempt by UNG to deal with whatever new regulations may be introduced by the CFTC and to allow us to permit creations of new shareholder units for investors,” says John Hyland, chief investment officer for U.S. Commodity Funds. “These natural gas-based swaps are not enough by themselves to allow us to either meet what we think such potential CFTC levels might be, or to permit us to prudently allow new creations. Still, we are making very good progress.”

The CFTC is expected to introduce position limits that restrict the amount of investment a specific fund may have invested in an individual commodity. While any regulations would likely impact dozens of exchange-traded products, UNG has received most of the focus, as tremendous interest in natural gas investments has caused the fund to increase more than sixfold this year, raising concerns that it now accounts for a significant portion of the natural gas futures market.

Although it has received approval from the SEC to create additional shares, UNG has elected to hold off on any new issuances until it is able to understand the full scope of any upcoming regulations. This has caused UNG to act as a closed-end fund, trading at a premium to its underlying value. Due to complex arbitrage mechanisms in place, ETFs usually trade at no more than a few basis points from the value of the underlying assets.

Swaps are essentially a bet between two parties on the movement on an underlying asset (in this case natural gas). Since the bet is made with a counterparty, such an agreement introduces counterparty risk, a potential drawback for many UNG shareholders. “Using alternatives may just turn out be a more expensive way of doing things for our shareholders. It could lead us to take on certain kinds of risk which we presently don’t have to take, or don’t have to take very much of, and at the far extreme, it could lead to the fund having to find a way to become smaller,” says Hyland.

Disclosure: No positions at time of writing.