Stellar May For UNG: Proof Of A U.S. Recovery

by on June 1, 2010 | ETFs Mentioned:

As the calendars turn to June and the second quarter begins to draw to a close, most investors are reeling from one of the worst five week stretches in recent memory–including even the tumultuous markets of late 2008. Back then it was the toxic real estate market in the U.S. that sparked a global sell-off that drenched equity markets around the world in red. This time around, it is a sovereign debt crisis in Europe that has spawned a wave of risk aversion and pummeled portfolios. Outside of inverse and fixed income ETFs, finding an ETF that delivered gains to investors in May is a daunting task. Oddly enough, it was one of the most certain ways to destroy value through an exchange-traded product that turned in one of the best performances during the recent chaos (see Five Equity ETFs That Held Their Ground In May).

The United States Natural Gas Fund (UNG), the same exchange-traded commodity product that slumped more than 50% last year and 20% in a single month this year (see How UNG Lost 20% In March), turned in a gain of more than 8% during May. This stellar performance came as equity markets around the globe were plummeting from the euro zone fallout and natural resource prices were in freefall. So how exactly did UNG manage to buck such a bearish wave of investor sentiment and turn in one of its best monthly performances ever? The answer may give some valuable insights into the status of the U.S. recovery and the short-term outlook for domestic equities.

Although technological breakthroughs have begun to change the manner in which the industry operates, natural gas remains largely a local commodity. Compared to crude, which is regularly transported globally from oil-rich countries to importing nations, natural gas generally makes a far shorter trip. That’s because natural gas remains a largely local commodity, since its physical properties make trans-Atlantic transportation impractical and expensive.

UNG’s Rally: A Leading Indicator?

In the current environment, this distinction has become important for two reasons. First, UNG has been immune to the fallout from the dollar’s recent rally. As risk aversion rises, investors have sought out safe havens to park cash (see Five ETF Safe Havens). This “flight to quality” has caused the U.S. dollar to surge, not only against the euro but against other emerging and developed currencies as well. The stronger greenback has weighed on commodity prices, sending crude oil into a well-documented freefall in recent weeks. Because crude and many other commodities are priced in dollars throughout the world, a strong U.S. currency makes them more expensive to international consumers. That drives down demand, which in turn pushes the dollar-denominated price lower as well. But the dollar’s strength is a non-issue for futures contracts on natural gas delivered at the Henry Hub in Louisiana, the underlying holdings of UNG.

Second, as strange as it may sound, the somewhat restrictive physical properties of natural gas have made UNG one of the purest plays on the U.S. economy right now. Wall Street’s gaze has been cast east across the Atlantic for the last several weeks, as U.S. markets (along with virtually every other stock market around the world) have taken their cues from Europe. With a global economy now more intertwined than ever, it doesn’t take long for a crisis in one corner of the globe to be felt worldwide. This phenomenon has been demonstrated all too well in recent weeks, as the storm clouds forming over Europe have overshadowed some rather encouraging developments in the U.S. economy.

Manufacturing in the U.S. is expected to have grown for the tenth consecutive month in May, while construction spending once again rose–albeit very slightly–in April. While unemployment remains a major concern in Europe and the U.S., there are definite signs of job creation in the manufacturing sector. According to data from the Labor Department, factories added 101,000 workers to payrolls in the first four  months of the year, the most successive gains since 2006. The Philadelphia Fed’s general economic index recently climbed to a five-month high, while the New York Fed gauge showed expansion for a tenth consecutive month. The U.S. economy still isn’t exactly booming, but there are some very promising signs in the flurry of data releases that have come out in recent weeks. And that has translated into a May mini-rally for UNG.

Home Country Bias

The end users of natural gas delivered at the Henry Hub in Louisiana are almost exclusively residences and businesses located in the U.S. The prices of the natural gas futures contracts that make up UNG depend on domestic demand, and are effectively immune to deteriorating demand equations outside of the U.S. And in May, the local economic indicators were largely positive, although most investors wouldn’t know it from glancing at their account statement.

The improving outlook for the U.S. manufacturing sector sent natural gas prices sharply higher in May, and the commodity’s physical properties effectively shielded prices from the euro zone fallout. UNG is far from a sure bet–contango in futures markets create some strong headwinds to overcome. But for investors looking to bet on the U.S. economy–while avoiding currency risk and any exposure to Europe’s woes–it’s an interesting option.

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Disclosure: No positions at time of writing.