UNG vs. USO: A Tale Of Two Commodities
The last two years have forced investors to reevaluate many of the relationships within financial markets that have historically guided investment decisions and shaped portfolio strategies. Massive stimulus plans have created unprecedented amounts of liquidity, which has in turn caused traditional correlations between asset classes to break down. The notion that developed economies will lead the global economy out of downturns has been challenged and shot down by upstart emerging economies. And the idea that a jump in the money supply will inevitably beget a surge in inflation appears to be under fire as well.
The relationship between natural gas and crude oil is another that was turned on its head in 2009, as two fuels that have traditionally moved in relative lock step developed a remarkable disconnect. This break translated into huge losses for investors who expected a reversion to the mean, and has clouded the outlook for these resources heading into 2010. A look at the performances of these commodities in 2009, and the exchange-traded products that purport to deliver exposure to them, reveals that a “new normal” has been established in the energy market.
Historical Relationships Break Down
While the correlation between these commodities has been far from perfect historically, crude oil and natural gas have generally followed similar paths. After reaching new highs in mid-2008, both tumbled more than 50% by year end as concerns about the impact of a prolonged economic downturn caused demand to sag. Both struggled to find direction through the early part of 2009, as equity markets continued to head towards bear market lows in early March.
But that’s where the paths diverged.
Boosted by prospects of an economic recovery, crude oil prices began to surge. “The price of oil in 2009 more or less tracked concerns about the economy,” writes Liam Pleven. “It fell at the start of the year and started to move higher in mid-February, as the worst fears about the financial crisis began to ease.” Indeed, the United States Oil Fund (USO), which is designed to track the movements of light, sweet crude oil, bottomed with the S&P 500, and exhibited a strong correlation with major equity benchmarks for the rest of the year. USO finished 2009 up 18.7%, while the S&P gained about 26% for the year.
USO moved roughly in line with the broad market in 2009, while UNG chartered its own path down.
But natural gas wouldn’t find a bottom for several more months, as a huge glut of supply weighed on prices through the first three quarters of the year. As the United States Natural Gas Fund (UNG) and USO headed in different directions, investors became increasingly bullish on natural gas, expecting that the relationship between the two commodities would eventually return. That bet proved to be a losing one, as natural gas fell from $5.622 per million British thermal units at the beginning of the year to a low of $2.508 in early September. UNG, which invests primarily in natural gas futures contracts, had dropped by nearly 62% on the year at that point. Although the fund recovered in the last three months of the year, it still finished 2009 as one of the worst performers, losing more than 55% (for more updates on the biggest ETF winners and losers, sign up for our free ETF newsletter).
Natural gas is widely touted as the “fuel of tomorrow” by several high-powered promoters enamored with the potential of a clean-burning and abundant energy source. But while it may very well be the fuel of the future, the fundamentals of today have weighed heavily on the commodity. Huge discoveries throughout the world, coupled with reductions in usage at power plants, have pushed inventories near all-time highs. Moreover, technological advancements have begun to transform natural gas a truly global commodity, opening up new supply channels (see this feature for a more in-depth look at the headwinds facing UNG).
One Thing In Common
Although spot prices of the underlying resources went in different directions for much of 2009, a common phenomenon contributed to the returns on both of these funds for the year. Due to consistent contango in futures markets, both of these funds performed significantly worse than the hypothetical returns on spot prices of the underlying commodities.
UNG and USO both employ a similar investment strategy, holding primarily near month futures contracts on natural gas and crude oil, respectively. Because these funds do not wish to actually take possession of the underlying commodities, they must “roll” their holdings each month as the contracts approach expiration, essentially selling near month futures and using the proceeds to purchase second-month contracts. When futures markets are in contango — meaning that tomorrow’s oil or gas costs more than today’s — returns to a futures-based strategy can be quickly eroded, since proceeds from the sale of near month futures won’t be sufficient to purchase the same amount of exposure through longer-dated contracts.
Natural gas finished 2009 down less than 1%, but UNG lost more than 55% on the year. Likewise, crude oil prices climbed nearly 80% during 2009, but USO delivered an annual return of just 18%. These performance gaps demonstrate the complexities associated with commodity investing, and highlight the fact that changes in spot prices are often a relatively minor driver of overall performance.
From is launch in April 2007 through the end of 2008, UNG maintained a strong positive correlation with USO. But throughout 2008, the relationship between these two funds became a negative one, befuddling investors who piled into UNG on the premise that gas prices would eventually catch up with oil. A relatively stable relationship between natural gas and oil has historically been one of the few relative certainties for investors. So the sharp disconnect over the last 12 months has investors wondering: is the correlation between the commodities a thing of the past, or was natural gas simply in need of a supply-driven downward correction?
As the calendar turns to 2010, the outlooks for natural gas and crude oil are cloudy, but it seems that the correlation historically exhibited by these resources may be returning. Judging by huge rallies in both UNG and USO in the year’s inaugural session, early indications are that both commodities will take their cues from the global recovery efforts. Although price drivers are far from identical — natural gas, for example, is far less vulnerable to geopolitical tensions in the Middle East — it seems that the relationship between oil and gas is strengthening once again.
The uncertainties facing these fuels are reflected in the gaping holes between various analyst estimates: Citigroup expects natural gas to average $4.75 per million BTU while Sanford C. Bernstein sees prices above $9.
So buckle up — 2010 should be another wild ride for energy ETFs.
Disclosure: No positions at time of writing.