Perhaps no exchange-traded product listed in the U.S. has seen the level of investor interest or been the subject of as much controversy as the United States Natural Gas Fund (UNG). UNG was launched in April 2007, and the fund was moderately successful during its first 18 months, growing to more than $700 million in assets at the end of 2008. But the success to that point was nothing compared to what lay ahead for the natural gas fund. Prices plunged as the double whammy of massive new discoveries and decreased domestic demand hit natural gas markets. Meanwhile, several figures with high profiles and deep pockets began campaigning for natural gas as the “fuel of the future,” leading many investors to believe that a major rebound in prices was inevitable.
The resulting surge in interest in UNG was impressive; cash inflows for the year totaled $5.6 billion, the fourth most of any exchange-traded product. UNG finished 2009 as the third largest commodity ETF, behind only GLD and SLV. Unfortunately for the investors responsible for the $5.6 billion in inflows, the year’s most popular ETF was also one of the worst performers (see charts of UNG).
Contango: The New Four-Letter Word
Contrary to what some investor believe, UNG does not own pipelines and storage facilities filled with natural gas. The underlying holdings consist not of the physical commodity, but of futures contracts. As such, the returns to the fund are impacted by three factors: 1) changes in the spot price of natural gas, 2) interest income on uninvested cash, and 3) the “roll yield” (in order to avoid taking delivery of natural gas, UNG “rolls” its holdings each month, selling near-month contracts and buying up second month contracts). In 2009, almost all of UNG’s return was attributable to the third of these factors.
Natural gas prices went on a wild ride in 2009, but finished up about where they started. The same couldn’t be said for UNG. After closely tracking changes in the price of the near-month NYMEX futures contracts for much of the year, steep contango in futures markets hammered the fund in the year’s final four months when gas prices finally began to recover. Natural gas prices rose, but the recovery was roughly in line with the market’s expectations. The monthly roll became a costly endeavor for UNG, and the fund’s returns began to lag far behind a hypothetical return on natural gas. For all of 2009, UNG lost more than half of its value despite the fact that spot natural gas prices finished the year less than 1% below where it started (see fundamentals of UNG).
The big gap between a hypothetical return on natural gas and the natural gas ETF led some investors to bash UNG as a flawed product. It’s not–the fund does exactly what it says it will do–but many don’t fully grasp the nuances of futures-based investing strategies (see What’s Wrong With UNG?).
2010: Freefall Continues
UNG’s performance in 2009 led some investors to look elsewhere for natural gas exposure (see Three ETF Alternatives To UNG), and inflows to the fund have slowed significantly; through the first two months of 2009, UNG saw cash outflows of about $400 million. The fund’s performance, however, has been similar to last year, as the freefall in share price has continued through the first two and a half months of 2010. The fund is down about 20% on the year and has hit new lows on multiple occasions (most recently following Thursday’s EIA inventory data release). With memories of 2009′s dreadful performance still fresh, many investors have assumed that contango is once again the culprit. While the result may be the same, however, the main driver of the negative performance so far in 2010 is more fundamental in nature (see more information on UNG’s fact sheet).
While it’s true that contango has eaten into returns a bit this year as well, the main driver behind UNG’s slide has been more fundamental in nature. The futures curve for NYMEX natural gas contracts is still upward-sloping, but the grade is moderate (May contracts were recently trading at about a 1.5% premium to April futures). This creates the potential for some adverse “roll yield” returns in UNG, but obviously doesn’t explain the 20% loss year-to-date (see UNG’s holdings page for a further breakdown of the contracts).
UNG has actually moved in lock-step with natural gas prices so far this year, as the majority of the fund’s returns have been attributable to changes in the spot price of natural gas.
The causes for continued declines in natural gas prices are numerous; warmer-than-usual weather, weak demand from factories and manufacturers, and expectations for significant increases in supply in coming years have all weighed on prices this year. It has been these fundamental factors, not the slope of the futures curve (or “tracking error”) that have accounted for UNG’s decline this year.
It’s worth noting that UNG started out 2009 much like it has started 2010–moving downward in unison with spot prices. The major disconnect last year didn’t arise until natural gas prices finally bottomed out and headed higher, so the correlation may drop when/if prices recover.
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Disclosure: No positions at time of writing.