Beyond UNG: Alternative ETF Plays On Natural Gas

by on November 10, 2009 | Updated June 17, 2010 | ETFs Mentioned:

When most ETF investors think of natural gas, they invariably think of the United States Natural Gas Fund (UNG), perhaps the exchange-traded product subject to the most regulatory scrutiny over the last two years. But while UNG is the $4 billion elephant in the room, it isn’t the only option for investors looking to gain exposure to natural gas prices. There are several exchange-traded products offering exposure to natural gas prices in various ways. And while these ETFs might not be as popular as UNG, that doesn’t necessarily make them any less effective.

iPath Dow Jones-UBS Natural Gas Sub-Index Total Return ETN (GAZ)

Natural Gas Processing PlantThe often overlooked iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN (GAZ) doesn’t maintain quite as high of a profile as its counterpart, which may a good thing given the uncertain regulatory environment. GAZ is an ETN that reflects the returns on an unleveraged investment in natural gas futures contracts. Because it is structured as an ETN, GAZ doesn’t actually invest in futures contracts, but rather promises to pay investors a return equal to the gain or loss on a hypothetical index of futures contracts (see GAZ’s fundamentals here).

Natural gas prices have plummeted over the last year as massive new discoveries have bolstered supplies while a pronounced and prolonged slowdown in the global manufacturing sector has weakened demand. Despite the decline in prices, investors have been clamoring to gain access to natural gas prices. UNG has seen cash inflows of about $5 billion in 2009 (through October), while GAZ has seen $165 million come in the door (see GAZ’s performance charts here). ETFdb Pro members can read more in our Oil & Gas ETFdb Category Report (if you’re not a Pro member yet, sign up for a free trial or read more here).

Since UNG and GAZ track similar benchmarks, the correlation between these products is very strong (greater than 0.99 over the last two years).

GAZ and UNG Have Shown Very Strong Correlation Over The Last Two Years

First Trust ISE-Revere Natural Gas Index Fund (FCG)

Unlike UNG and GAZ, this ETF invests not in natural gas futures, but rather in stocks of companies that generate a substantial portion of their revenues from the exploration and production of natural gas. The methodology for constructing the underlying holdings of the index underlying FCG is as follows (see our report on “alpha ETFs” for a complete breakdown of ETFs tracking dynamic or intelligent indexes):

  1. Establish total population of U.S.-listed stocks involved in natural gas exploration and production
  2. Eliminate stocks whose natural gas proven reserves do not meet certain requirements
  3. Rank all candidate stocks by: 1) P/E ratio, 2) P/B ratio, 3) return on equity, and 4) correlation to natural gas futures prices
  4. The rankings are averaged and the top 30 stocks are then selected for inclusion in the index (see all of FCG’s holdings here)

Between its inception in late 2007 and the beginning of 2009, FCG maintained a relatively strong correlation with UNG. But that relationship has turned negative since the start of the year, as the recovery in equity markets has boosted FCG while further declines in natural gas prices (and the continuation of contango in natural gas markets) has pushed UNG down further:

UNG and FCG Have Diverged In 2009

JP Morgan Alerian MLP Index ETN (AMJ)

JP Morgan offers an interesting way to gain indirect exposure to natural gas that differs from FCG (see AMJ’s technicals here). The JP Morgan Alerian MLP Index ETN (AMJ) is linked to a benchmark that measures the performance of the energy master limited partnerships (MLPs). MLPs are limited partnerships that are publicly traded. The majority of MLPs currently operating in the U.S. focus primarily on the energy infrastructure industry, owning assets such as pipelines that transport crude oil and natural gas. Because MLPs tend to generate fee-based revenues, their performance is not directly tied to commodity prices.

AMJ pays quarterly coupons linked to the cash distributions paid by the MLPs in the underlying index. Investments in MLPs are attractive to certain investors because there are no K-1 forms associated with the investment – coupons are reported as ordinary income (see more on AMJ’s fact sheet).

The top five components of AMJ (as of August 21, 2009) included:

Company Weighting
Kinder Morgan Energy Partners 12.2%
Enterprise Products Partners 10.7%
Plains All American Pipeline LP 6.4%
Energy Transfer Partners LP 5.8%
Kinder Morgan Management LLC 4.4%

Coming Soon: Jefferies Natural Gas Equity ETF

Jefferies has filed the prospectus for another natural gas ETF that will directly compete with FCG. Similar to First Trust’s fund, this ETF will invest in the stocks of companies operating in the natural gas industry and will give higher weightings to companies with higher proved reserves of natural gas. The Natural Gas Equity ETF from Jefferies will, however, be different in a few ways. The Jefferies fund will have about 55 underlying holdings, compared to 30 for FCG. As of June 30, 2009, about 75% of the index underlying the Jefferies index consisted of U.S. companies, compared to 100% for FCG.

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Disclosure: No positions at time of writing.