UNG vs. USO: Decoupling Or Correction?

by on May 18, 2010 | ETFs Mentioned:

The impressive rise of the ETF industry has changed the business of investing in countless ways. Low-cost exposure to indexes has brought increased scrutiny on the concept of active managements and traditional mutual funds. Immediate exposure to entire markets and sectors has made individual stocks a thing of the past for some active investors. And the universe of investable assets expanded significantly; everything from agriculture to hedge funds to volatility is now accessible through a single exchange-traded security (see The True Cost Of Active Management).

In some cases, ETFs have facilitated the transition of everyday resources into hot investment trends. The United States Natural Gas Fund (UNG) is one such example; as investors talked themselves into natural gas as the “next big thing,” UNG became the preferred means of gaining exposure. Because UNG’s holdings consist of natural gas futures, it doesn’t necessarily track changes in the spot price of natural gas (and it doesn’t claim to). Still, for investors looking to gain exposure to natural gas prices, it’s one of the best options available (see How Contango Impacts ETFs).

Natural Gas: The Bull Case

The investment case for natural gas was made on several levels. Many investors were swayed by the argument that positioned natural gas as a viable alternative to foreign oil; a clean-burning fuel that exists in abundance within U.S. borders figures to be in demand as consumers and corporations transition towards clean energy alternatives and frustration with high crude oil prices builds. Add in the fact that natural gas has been proven as a viable source of power for everything from power plants to automobiles, and it seems like a “can’t miss” investment idea. From a high level, the case for natural gas as the “fuel of the future” was a logical one (see Six Reasons UNG Is Ready To Surge).

But there was also a technical case for natural gas. The relationship between prices of natural gas and crude oil, which had been relatively stable for decades, had seemingly broken down. After moving in unison for more than two decades, the paths of natural gas and crude oil began to diverge in early 2009. As equity markets bottomed out and the recovery took root, crude oil prices headed higher. But natural gas didn’t get the same boost; prices continued to plunge as new discoveries and a lag in industrial activity provided downward pressure.

The Gap Widens

As oil continued to rise while natural gas languished, many believed that the price of natural gas relative to crude oil had become too cheap, and that a correction was inevitable. With a big downward slide in oil seeming unlikely, the bet on a spike in natural gas prices became a popular one. Crude and natural gas aren’t perfect substitutes–automobiles are a great example of the lack of overlap–but it was generally believed that the prices of these fuels would move in lock step as industrial users attempted to minimize costs. But despite an obvious bullish interest in natural gas–UNG took in more than $5.5 billion in cash in 2009–natural gas prices continued to slide until late in 2009 (see What’s Wrong With UNG?).

The Tables Turn

A quick look at a performance chart of UNG and the United States Oil Fund (USO)–one of the most popular ETFs offering exposure to crude oil– highlights this disparity. What isn’t quite as obvious, however, is the reversal of recent trends over the last month:

Period UNG USO
1 Week 9.6% -6.7%
2 Week 9.5% -15.8%
4 Week 6.3% -16.6%
YTD -24.3% -13.8%
52 Weeks -52.3% 8.2%

As crude oil has entered into a well-publicized freefall amidst chaos in Europe and a strengthening U.S. dollar, natural gas has shown surprising resiliency. Over the last two weeks, USO has lost about 16% of its value; UNG is up almost 10% over that period (see Five Reasons USO Is Due For A Comeback).

These wildly different performances in recent sessions seem to indicate that one of two things is now true:

  1. The temporary pricing inefficiency between crude oil and natural gas is now in the process of correcting itself.
  2. The relationship between natural gas and crude oil, once thought to be as certain as death and taxes, is officially–well, dead.

The latter appears to be the more likely scenario. While there is some overlap among the drivers of natural gas and crude oil, these factors are more different than they are alike.

On the supply side, the differences are obvious. Unlike crude oil, natural gas remains largely a local commodity, although technological breakthroughs have begun to facilitate long-distance transport. So supplies of natural gas depend on new discoveries made in the U.S., while crude oil stocks are impacted by OPEC’s decisions and, occasionally, geopolitical tensions in the Middle East. The nuances of “global” and “local” also explain another reason for the recent divergence in returns; a stronger dollar weakens oil prices (since it becomes more expensive to international consumers), while natural gas prices are generally immune to swings in exchange rates.

There are some major differences on the demand side of the equation as well. Natural gas prices have received a boost from expectations of unseasonably warm weather in the U.S. (which translates into increased air conditioner usage), an uptick in factory activity, and a slight decline in the closely-monitored natural gas rig count. Oil, on the other hand, has largely taken its cues from across the pond; worries about a recession in Europe and general economic uncertainty sent prices briefly below $70 per barrel on Monday.

Nail In The Coffin

The last several years have caused investors to reexamine several relationships they once took for granted (like low correlations between stocks and bonds). It’s possible that we’re now seeing proof that the bond between crude oil and natural gas still holds strong. But more than likely, we’re actually witnessing a final nail in the coffin.

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Disclosure: No positions at time of writing.