In 2009, billions of investor dollars flooded into the United States Natural Gas Fund (UNG) in an attempt to capitalize on an anticipated jump in price as the clean-burning fuel becomes the energy source of the future. Spot gas prices finished the year little changed — down less than 1% — but UNG lost more than half its value, as the complexities of a futures-based strategy ate into returns. Despite seeing more than $5.6 billion in cash inflows, UNG finished 2009 with $4.6 billion in assets.
Some investors mistakenly believe that UNG is designed to track the spot price of natural gas, an investment objective that would require the fund’s managers to buy and physically store natural gas. But such a strategy is impractical and would be prohibitively expensive to implement. Rather, UNG invests in near month futures contracts on natural gas, “rolling” its holdings as they approach expiration each month to avoid taking physical delivery.
While an uncertain regulatory environment and perhaps even the fund’s own popularity contributed to UNG’s performance in 2009, the primary culprit behind the fund’s big annual loss was contangoed futures markets. Contango refers to an upward-sloping futures curve — meaning that the price of a commodity for future delivery is higher than the spot price. While contango can reflect the market’s expectations on changes in price, it may also account for interim storage costs incurred by the forward seller.
A contangoed market becomes an issue when the expiration of near-month contracts approaches and UNG must “roll” its holdings to second month contracts. An upward-sloping futures curve means that the fund will be forced to sell near month contracts for less than the cost of second-month futures, inevitably resulting in either an erosion in the natural gas exposure of the fund or a required cash infusion. For a more in-depth look at these issues, see What’s Wrong With UNG?
After a bitterly disappointing 2009, a bitter cold across much of the country has sent UNG off to an impressive start in 2010. Unseasonably cold weather from the Great Lakes to Texas has caused a surge in demand for heating, adding momentum to withdrawals from natural gas inventories that typically occur in winter months.
Boosted by these improving fundamentals, UNG gained more than 7% in the year’s first three sessions, giving investors hopes that a new year will mean a new direction for one of the most popular exchange-traded products. While predicting future weather patterns (and therefore future inventory drawdowns) is essentially a crap shoot, movements in spot natural gas prices aren’t the only factor impacting this fund. UNG could get a more predictable boost in coming weeks from a more technical, and perhaps unexpected, source (for updates on UNG and other popular ETFs, sign up for our free ETF newsletter).
Contrary to popular belief, use of a futures-based strategy doesn’t condemn a fund to consistently trail behind a hypothetical return on spot prices. In certain environments, returns on a futures portfolio may exceed changes in the spot price of the underlying commodity. And the natural gas market may be entering into one of these environments now. After sloping upwards for much of 2009, the forward curve for NYMEX natural gas futures contracts has inverted, at least in the short term. April contracts are trading for less than March futures and March contracts cost less than near-month February futures.
This environment could create an opportunity for UNG to actually turn a profit on its “roll” process, especially if spot prices move sideways but expectations for an upcoming dip in prices persist.
It should be noted that the backwardation is relatively minor — March futures recently traded at only about a 1% discount to February. It’s also important to understand that backwardation in the futures market doesn’t guarantee positive returns or even outperformance of a hypothetical return on spot prices. But after riding into a stiff wind for much of last year, investors in UNG should be happy to finally have a breeze at their back.
Disclosure: No positions at time of writing.