The United States Natural Gas Fund (UNG), the largest oil and gas exchange-traded product, recently issued new shares for the first time since July. The lengthy interval between new share issuances certainly wasn’t due to a lack of demand. In recent months, investors have been clamoring to get access to natural gas, bidding up shares of UNG to a huge premium and causing the fund to look and act more like a closed end fund than an ETF.
Facing an uncertain regulatory environment and unrelenting demand from investors, UNG has for months found itself between a rock and a hard place. If UNG had issued new shares to satisfy investor demand, the fund would have put itself in jeopardy of violating regulations expected to be issued by the CFTC regarding position limits on futures contracts. In such a scenario, UNG could potentially be forced to sell off a huge chunk of its holdings in the near future, to the detriment of shareholders. But by refusing to issue new shares, UNG subjected shareholders to a wild ride, as the premium on the fund soared to near 20% above net asset value (NAV) this summer.
The issuance of new shares seems to indicate that UNG has found a solution to its dilemma, at least for the time being. But the latest move doesn’t come without its risks.
The events leading to UNG’s
- July 2009: Cash inflows into UNG exceed $4 billion for the year, and the fund petitions the SEC to increase the number of shares it could issue from 200 million to 1.2 billion. Although petitions for additional shares usually get rubber-stamped, the SEC takes no immediate action on UNG’s requests.
- July/August 2009: The Commodity Futures Trading Commission (CFTC) holds hearings to determine whether position limits are necessary to curb excessive speculation in energy markets. “No longer must we debate the issue of whether or not to set position limits,” said CFTC Chairman Gary Gensler. “There are three important questions that do remain: Who should set position limits? Who should be exempted from position limits? And at what level should position limits be set?”
- August 2009: UNG finally received SEC approval to issue new shares, but elects not to, reportedly in anticipation of upcoming legislation from the CFTC.
- Late August 2009: Still hesitant to issue new shares in exchange for futures contracts, UNG begins to explore alternative options for gaining exposure to natural gas prices, reportedly entering into a $500 million natural gas total return swap.
- September 2009: Investor demand for exposure to natural gas prices drives UNG’s premium to NAV up to nearly 20%, a massive spread for an exchange-traded product.
- September 2009: UNG announces that it will begin issuing new shares on September 28.
- October 2009: UNG issues 7 million new shares, worth $79 million, that are backed by a total return swap with an investment grade counterparty, according to the company’s Web site.
While the end result is similar, the share creation process for UNG has changed significantly. Traditionally, institutional investors known as Authorized Participants (APs) could exchange near-month natural gas futures contracts for new shares of UNG. But now UNG is looking to avoid increasing its futures position, fearing that it would be forced to sell off a massive position when new regulations are introduced. So instead of exchanging new shares for futures contracts, UNG will accept only privately-negotiated swap contracts.
The new shares have been effective in reducing the premium on UNG, and appear to provide a new arbitrage mechanism to keep share prices in lock step with the fund’s underlying value. But the shift in strategy isn’t without its risks. Unlike natural gas futures traded on the ICE or NYMEX exchanges, swaps introduce investors to the credit risk of the counterparty in the transaction.
Moreover, the new arrangement puts APs in charge of establishing privately-negotiated contracts if they wish to act as a middleman for UNG shares, a task that can potentially be both time consuming and expensive. UNG’s hefty premium to NAV offered plenty of incentive for the initial new share creations, but if UNG begins to trade close to its NAV, creation activity may become less appealing.
Finally, the regulatory environment remains cloudy, and the CFTC seems determined to curb speculation in energy markets. While UNG has taken bold steps to comply with current (and anticipated future) regulations, there’s no telling what the future may hold.
Disclosure: No positions at time of writing.