UNG: Not A Scam, But A Tough Bet To Win

by on May 28, 2010 | ETFs Mentioned:

There aren’t many industries out there that can match the impressive growth of ETFs over the last few years. But natural gas might be close. Driven by increased interest in cultivating crude oil alternatives, production of shale gas has surged in recent years, and shows no signs of slowing down anytime soon. According to data from the U.S. government, U.S. shale gas production topped 2 trillion cubic feet in 2009, up more than 70% over the previous year. Massive new discoveries of natural gas reserves, as well as technological breakthroughs that improve the efficiency with which such reserves can be accessed, have helped to increase the market share of natural gas in the U.S. energy equation.

It’s clear from Big Oil’s recent buying spree that natural gas is expected to be a primary source of energy in the future. Royal Dutch Shell announced today that it will purchase natural gas explorer East Resources for $4.7 billion “in a transaction that underscores the frenzied global interest in North American shale-gas production.” Shell’s expansion of its natural gas operations comes months after Exxon Mobil acquired XTO Energy for about $30 billion; Schlumberger and Baker Hughes have also been active in the M&A space in recent months.

While these developments have helped the natural gas industry boom, they’ve also put significant downward pressure on prices. After hitting an all-time high in late 2005 in the wake of supply disruptions from Gulf Coast hurricanes, natural gas prices tumbled more than 80% over the next four years as a dismal economic outlook and surging supplies combined to drag down the market value. But since bottoming out in late 2009, natural gas has staged an impressive rally. Over the last nine months, the price of a million British thermal units of natural gas has climbed from about $2.75 to more than $4.00, an increase of nearly 45%.

UNG Lags Behind

Investors in the United States Natural Gas Fund (UNG), however, have not benefited from the jump in prices. UNG, which has nearly $3 billion in assets, has lost about 27% on the year and more than 50% over the last 52 weeks. That has some investors crying foul, frustrated that the natural gas ETF hasn’t reflected the run-up in spot natural gas prices. But those who have been burned by the natural gas will have to find a mirror if they’re looking to assign blame. UNG does exactly what its prospectus and web site say it will do; establish exposure to natural gas prices “as measured by the futures contract on natural gas traded on the New York Mercantile Exchange.”

UNG doesn’t offer exposure to spot natural gas prices, and it doesn’t purport to. Instead, it invests in near month natural gas futures contracts, rolling those futures to the second month as the expiration approaches (see UNG holdings). So while any allegations of foul play are baseless, the notion that it’s tough to make money in the natural gas ETF has some merit.

The market for natural gas futures in currently in contango, meaning that longer-dated contracts are more expensive than futures closer to expiration. Recently, December contracts were trading at $5.25, about 20% higher than July futures. That results in some strong headwinds for UNG; natural gas prices must at least keep up with the futures curve just to break even. As the last several months have shown, UNG can lose ground even when spot prices rise.

The upward-sloping curve reflects the market’s expectations for prices, but also costs incurred by storing natural gas. There’s a reason why investors looking to gain exposure to natural gas prices do so primarily through futures contracts. Establishing exposure to spot prices would be prohibitively expensive, requiring a network of underground pipelines and storage facilities. If you thought actively-managed mutual funds were expensive (see The True Cost Of Active Management), the sticker shock on exposure to spot natural gas prices might be fatal.

UNG Alternatives

Physically-backed ETFs are viable for resources with an extremely high price-to-weight ratio (such as precious metals), but would necessitate sky-high expense ratios for most commodity products (see Why The Aluminum ETF Is A Terrible Idea). UNG might not be the smartest investment play; those with a bullish outlook on natural gas might be better off in a fund like FCG or OOK (see ETF Alternatives To UNG).

But the natural gas ETF certainly isn’t a scam. And for investors looking for exposure to natural gas prices, it’s one of the best options available.

Disclosure: No positions at time of writing.