How UNG Lost 20% In March

by on April 1, 2010 | ETFs Mentioned:

March was one of the best months in recent memory for most investors. Equity markets surged on renewed consumer confidence and continued strong demand from emerging markets. The ETFdb 60 Index, a benchmark measuring the performance of asset classes available through ETFs, climbed 3% during the month, an impressive gain that was held in check by the significant bond allocation in the index.

But not all asset classes enjoyed a March to remember. Fixed income investments were relatively flat, while some broad-based commodity funds inched lower. And few funds have ever turned in a monthly performance worse than the United States Natural Gas Fund (UNG) did in March. Investors in UNG checking their accounts today will see that the fund slid by more than 20% during the month of March. And unfortunately, that big red number is no April Fool’s Day gag.

Behind The Freefall

So how did UNG lose 20% in just 23 trading days? Surprisingly, the usual suspect wasn’t to blame this time.

UNG implements a futures-based strategy to accomplish its objective of tracking changes in the price of natural gas. As such, the fund’s value is impacted by three factors: 1) changes in the spot price of natural gas, 2) the “roll yield” incurred or earned when expiring contracts are exchanged for next-month contracts, and 3) interest earned on uninvested cash. UNG became a case study in contango last year, as the second of these became the dominant factor in the fund’s returns. Natural gas prices finished 2009 about where they started, but UNG lost more than 50% of its value (see What’s Wrong With UNG?).

So many investors assumed that the same forces are at work in 2010, with steep contango in futures markets eating away at UNG’s returns. But that hasn’t really been the case. The futures curve remains upward-sloping, but the grade is relatively moderate. Contango played a relatively small part in UNG’s March swoon. The real cause of the downfall was more fundamental in nature, as a “perfect storm” of economic conditions combined to send spot natural gas prices sharply lower. Prices for near month Henry Hub natural gas futures declined by about 19.6% in March, accounting for the bulk of UNG’s slide.

Supplies Surge

In recent years, massive new discoveries of natural gas reserves have significantly expanded potential North American supplies of the fuel. March saw some of these discoveries transition into actual production, most notably the kickoff of a new Royal Dutch Shell platform in the Gulf of Mexico. The Perdido platform can produce up to 20 million cubic feet per day of natural gas, boosting the capacity of a network of energy infrastructure that is already responsible for 15% of U.S. natural gas production.

Firing up this platform represents only a fraction of the potential natural gas haul in the region; there have been 18 discoveries in the area, but Perdido is the first platform to begin pumping oil and gas. As such, the potential increase from the region is significant, and could create a prolonged drag on prices.

Increases in natural gas supplies haven’t been limited to the Gulf of Mexico. The Colorado Senate recently approved a bill that will boost natural gas production in the state by 15%. The measure was enacted to allow several coal-fired plants around Denver to convert to natural gas-burning facilities, so demand for the fuel is rising along with supply. Still, the ability to quickly boost production of natural gas reflects the abundance of supply in the current environment.

Spring Comes Early

The suspicion that natural gas supplies were on the rise was confirmed by multiple data releases last month. On March 25, the Energy Information Administration (EIA) released its weekly natural gas storage report, a statistical bulletin that details natural gas inventories in the U.S. The report indicated that gas in underground storage increased by 11 billion cubic feet for the week ended March 19, meaning that the winter drawdown season had come to an end at least two weeks ahead of schedule. The report also indicated that gas stocks were 8% above the five year average level, sending natural gas prices (and UNG) tumbling. Big movements in UNG after the weekly release are nothing new (see Thursdays With UNG), but the unexpected rise in inventories was particularly bad news, and the fund lost 3% alone that day.

With warmer weather across the country expected in April, residential demand for natural gas should continue to drop and stockpiles should begin to grow again. The focus will now shift to industrial users of natural gas to drive demand. Although recent months have seen a sustained economic recovery, many factories have still not returned to pre-recession capacity, a fact that has taken a bite out of natural gas demand.

Time To Buy?

Following the big drop in March some investors have become bullish on natural gas, hoping that the recent decline was a bit overdone. With hundreds of rigs still idled, all indications are that supplies will continue to rise in coming months, especially with winter seemingly behind us. These factors, along with continued contango in futures markets, will provide strong headwinds to a fund that turned in one of the most disappointing first quarter performances.

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Disclosure: No positions at time of writing.