In a cruel twist for countless investors, one of the most popular ETF investments of 2009 has also been one of the worst performers. Most ETFs equity and bond ETFs have posted huge gains this year, with several international (HAO and RSX, just to name two) and sector-specific equity funds (such as PKOL) gaining more than 100%. Even among commodity exchange-traded products, the results have been generally stellar: GLD’s rise (up 38%) has received the most attention, but most other commodities have delivered solid gains as well. The diversified PowerShares DB Commodity Index Fund (DBC), which includes exposure to more than a dozen different commodities, is up more than 15% year-to-date (see all of DBC’s exposure on its holdings page).
Standing in sharp contrast to the numerous big winners is the United States Natural Gas Fund (UNG), which, through October, had seen cash inflows for the year of about $5.4 billion but had total assets of only $4.0 billion (see UNG’s performance charts here). After losing almost 15% in its last four trading sessions, UNG is now off more than 60% for the year, ranking it among 2009′s worst performers. But the old adage “once burned, twice shy” apparently doesn’t apply to natural gas investors. Despite racking up huge losses, cash continues to flow into UNG (October inflows were $464 million), and it remains one of the most active ETFs (average daily volume is a staggering 30 million shares). What many investors saw (and continue to see) as a surefire bet has turned into the ultimate portfolio money sink.
So what’s wrong with UNG? The answer to the question on the minds of countless “twice burnt” investors is a two-parter:
1) Fundamentals > Hype
2) Contango, contango, contango.
Fundamentals > Hype
UNG’s assets swelled this year to more than $4 billion on inflows from an incredibly broad group of investors. Those expecting to see some major hedge funds and institutions unmasked as major holders of UNG were proved wrong. The list of UNG owners isn’t exactly a “Who’s Who” of the investment community, but rather a collection of relatively small, mostly individual investors.
The high level case for natural gas as the next hot investment is a relatively easy one to make (or to buy). Just ask T. Boone Pickens. Natural gas is at the center of the billionaire businessman’s plan to reduce American dependence on foreign oil. The basics of the “Pickens Plan” call for huge investments in wind turbines to provide much of the nation’s electricity, freeing up natural gas currently used to fuel power plants to be used instead as fuel for cars, trucks, and industrial vehicles. Pickens isn’t the only one holding out natural gas as the “fuel of the future.” Countless pundits believe that natural gas is the answer to the energy woes of the U.S., a scenario that obviously implies huge surges in demand in coming decades.
Massive demand for natural gas may be the story of the future, but massive supply is the story at present. For the week ended November 27, natural gas storage in the U.S. stood at 3.837 trillion cubic feet, 14% higher than last year and 14.5% higher than the five-year average. Inventories of natural gas are near capacity, and have been for some time (see UNG’s technicals here).
The drivers of this glut in supply are numerous. Idle factories have reduced the quantities of gas needed to power the still-recovering manufacturing sector, causing supplies to surge. While the manufacturing industry will likely turn around at some point, other reasons behind the glut aren’t so “temporary.” Advancements in technology have made liquefied natural gas, which has been temporarily converted to liquid form, more prevalent. This facilitates global transport of a commodity that has historically been a regional resource, and could significantly expand the supply base open to domestic end-users.
Perhaps more importantly, huge discoveries of natural gas reserves have been made in the U.S. in recent years, including the enormous Haynesville shale in northwest Louisiana. “Every study of natural gas reserves indicates we have not just an abundance, but a super-abundance of natural gas in traditional fields and in shale deposits under Texas, Arkansas, Louisiana and Appalachia,” wrote Pickens (along with Senator Orrin Hatch) for the Salt Lake Tribune. This observation, used as support for his plan, goes a long way in explaining the downward path of prices this year (see UNG’s fundamentals here).
Contango, Contango, Contango
For the most part (some precious metals funds are exceptions), commodity exchange-traded products don’t buy or store the physical commodities with which they are associated. They use a futures-based strategy to gain exposure, investing in exchange-traded futures contracts that generally maintain a strong correlation with movements in the spot price of the underlying assets.
But the correlation is far from perfect. Returns to a futures-based investment strategy depend on three things: 1) changes in the price of the underlying asset (in this case, natural gas), 2) the “roll yield,” and 3) interest earned on collateral for futures contracts. The first factor is a matter of economics, and the third is negligible in the current low-interest rate environment. But the roll yield paid (or earned) in a futures-based investment strategy can account for a material portion of the total return (for more insights into how complexities of ETFs can impact your bottom line, sign up for our free ETF newsletter).
When futures markets are in contango (as the natural gas market has been for some time), near-month contracts cost less than far-month contracts, reflecting both market expectations of a rise in price and any costs associated with storage and transportation. Because UNG doesn’t want to actually take possession of the natural gas underlying its futures contracts, it “rolls” its holdings on a monthly basis, selling near month futures and buying up second-month futures. In the current environment, if UNG sold 100 contracts for January delivery for $4.53, it would receive enough proceeds to buy only about 98 contracts at $4.62.
This loss may not seem material, but when contracts are rolled on a monthly basis, the yield can begin to add up if the price of the underlying commodity doesn’t rise as expected. If prices go down, the negative returns can be exacerbated by losses from the roll process. “Natural gas investors have had absolutely the worst of all worlds,” writes Dave Nadig for Index Universe. “Not only has the spot price just been slaughtered this year…[but] the contango in the natural gas market has been crippling, meaning not only were you an idiot for being in natural gas, you were even more of an idiot for being in natural gas futures.”
If spot prices had gone up this year, the roll yield associated with natural gas futures likely would have been offset to some degree. But with both spot prices and contango working against investors, UNG has sunk.
It should be noted that futures-based strategies won’t always underperform spot prices: if the futures curve is downward-sloping, investors may be able to roll their contracts at a lower price, pocketing some cash while maintaining the same level of exposure (for more on UNG, see the fund’s fact sheet here).
Who’s To Blame?
UNG is not a flawed product. It does exactly what its prospectus says it will do, and is still one of the best options for investors looking to gain exposure to natural gas. It has become so popular in part for these very reasons. Investors who have incurred big losses in the fund have no one to blame but themselves.
“Know what you own” may sound like obvious advice, but in the complex world of commodity investing, this wisdom is perhaps more important than ever.
Disclosure: No positions.