Natural Gas ETFs: Seven Ways To Play

by on August 5, 2010 | ETFs Mentioned:

As more issuers have rushed into the ETF game and waves of cash inflows have contributed to surging asset levels within the industry, investors find themselves with more options than ever before. Once upon a time, exposure to a specific country or sector through ETFs was a binary decision; investors either had it, or they didn’t [use our country lookup tool to find all ETFs with exposure to a specific economy]. Now many corners of the ETF industry offer an impressive level of granularity, with numerous options for tailoring exposure to meet exact specifications.

This trend is evident in a corner of the domestic energy market that was largely overlooked until only a few years ago. Natural gas has been a part of most Americans’ lives for some time, but until recently very few viewed it as in investment opportunity. As talk of developing alternatives to foreign oil was intensifying, massive discoveries of natural gas reserves were being made across the U.S., coincident developments that sparked a race to tap the reserves and a spike in interest within the investment community. Within the last year, Big Oil has started making big bets on natural gas through major acquisitions, further strengthening expectations that a shift in the energy landscape is underway.

For investors looking to gain exposure to natural gas through ETFs, there is no shortage of options. Below, we highlight seven products that go about establishing this exposure in very different ways [for more ETF ideas, sign up for our free ETF newsletter]:

United States Natural Gas Fund (UNG)

Most investors seeking out exposure to natural gas prices gravitate towards UNG, which currently has almost $3 billion in assets. UNG invests in near-month natural gas futures contracts traded on the NYMEX, rolling its underlying holdings as the expiration approaches. UNG’s popularity has at times been its undoing; at one point it was estimated that this fund controlled as much as 90% of the open interest in near-month natural gas contracts. Because UNG rolls its holdings on a specific (and publicly-available) timetable, the potential for traders to front run the massive fund exists [see Five Drivers Of UNG's Spring Rally].

iPath Dow Jones-UBS Natural Gas ETN (GAZ)

GAZ is very similar to UNG in many ways; both offer exposure to a portfolio comprised of near-dated natural gas futures contracts. The correlation between UNG and GAZ is nearly perfect, and the historical returns generated by these products are almost identical. But there are a few key differences as well. Unlike UNG, GAZ is structured as as exchange-traded note, meaning that it is a senior, unsubordinated, unsecured debt security issued by Barclays Bank. There are both pros and cons to the ETN structure. On the plus side, GAZ delivers the returns of a hypothetical benchmark; there is no manager that must go out into the market and conduct the roll process. That allows for lower tracking error and lower expenses. But because GAZ is a debt security, investors are exposed to some degree of credit risk; if the issuing institution goes under, investors will have to get in line with the rest of the creditors.

First Truse ISE-Revere Natural Gas ETF (FCG)

For investors looking to avoid the impact of contangoed futures markets, FCG may be an interesting option. This ETF tracks the ISE-Revere Natural Gas Index, a benchmark comprised of companies that derive a substantial portion of revenues from the exploration and production of natural gas. Potential index members are ranked on four metrics: price-to-earnings, price-to-book, return on equity and correlation to gas futures prices. That fourth ranking is designed to ensure that FCG’s components have a history of moving in unison with gas prices.

One other noteworthy aspect of the index underlying FCG: it utilizes an equal-weighted methodology, meaning that the fund won’t be heavily concentrated in a handful of mega cap companies.

Oklahoma ETF (OOK)

OOK is one of two state-specific ETFs available to investors (along with TXF). This fund tracks the SPADE Oklahoma Index, a modified market capitalization weighted index that seeks to measure the performance of publicly-traded companies with corporate headquarters in Oklahoma or that maintain significant operations within Oklahoma. A breakdown of OOK’s holdings shows that about 60% of assets are in the energy sector, and several of the stocks to receive the biggest weightings operate within the natural gas space, including Devon Energy, Chesapeake Energy, and ONEOK Partners.

OOK isn’t a “pure play” on natural gas in the way that other ETFs on this list are, since it offers exposure to other corners of the economy as well. But for investors looking for a fund tilted towards that specific corner of the energy sector, it makes an intriguing option.

E-TRACS Alerian Natural Gas MLP Index (MLPG)

This recently-launched ETN is a part of the recent MLP boom within the ETF space; the last year has seen a tremendous surge in interest in this unique corner of the domestic energy market. MLPG is linked to the Alerian Natural Gas MLP Index, a benchmark that is an equal-weighted composite of the 15 largest natural gas infrastructure Master Limited Partnerships by market capitalization. These companies earn the majority of their cash flow from the transportation, storage, and processing of natural gas.

While MLPG has a narrow focus on companies operating in the natural gas space, it won’t necessarily exhibit a strong correlation to natural gas prices. That’s because MLPs generally own infrastructure assets such as pipelines, and generate fee-based revenues from the transfer of commodities. So revenues of MLPs tend to be correlated with demand for energy commodities, which is generally less volatile than commodity prices.

Direxion Daily Natural Gas Related Bull 2x Shares (FCGL)

This leveraged ETF seeks to deliver daily returns equal to 200% of the daily performance of the ISE-Revere Natural Gas Index, the same benchmark underlying the First Trust fund profiled above (that should explain this fund’s ticker). FCGL is also a relatively new addition to the ETF product lineup; this fund started trading in July.

Direxion Daily Natural Gas Related Bear 2x Shares (FCGS)

This ETF serves as FCGL’s bear counterpart; it seeks to deliver daily returns equal to the inverse of 200% of the daily movement in the same natural gas benchmark. Natural gas prices tend to exhibit particular volatility on Thursdays around the release of weekly inventory data; expect these leveraged funds to turn in some impressive trading volumes when stockpile data comes out [see Thursdays With UNG].

Disclosure: No positions at time of writing.