The Definitive Guide To Natural Gas ETFs: Natural Gas ETF Investing 101

by on October 15, 2009 | Updated June 24, 2010

With each monthly asset flow report, it becomes more apparent that the rise of the ETF industry has transformed the investing landscape in more ways than one. The exchange-traded structure is widely praised for providing an efficient mechanism for investors looking to shed the high costs of active management to embrace tactical asset allocation and indexing strategies.

Natural Gas Rich RussiaBut ETFs have also played a significant role in expanding the universe of investment options for millions of investors. ETFs (and their ETN and ETC cousins) have made geographies, asset classes, and investment strategies that were once available only to large institutional investors easily accessible to millions of investors. Van Eck offers a line of exotic country-specific ETFs, including the Market Vectors Vietnam ETF (VNM) and Africa Index ETF (AFK). ProShares and Direxion offer a line of 2x and 3x leveraged ETFs that are incredibly popular among sophisticated day traders. But perhaps the biggest barrier knocked down by ETFs is the one that stood between the vast majority of investors and commodities.

Over the last four years, billions of dollars have flowed into exchange-traded products offering investors exposure to prices of various natural resources, ranging from crude oil to corn and wheat to gold and silver. But among the most popular commodity funds are natural gas ETFs.

These funds can serve a variety of purposes, including short term speculation on price movements and longer-term hedges for major users of natural gas. But these funds are complex securities, and come with a number of risks that all investors should consider before jumping in.

Natural Gas 101

Natural gas is an important source of electricity generation with a variety of both industrial and residential uses. Natural gas is popular because it burns more cleanly than fossil fuels such as oil and coal. Natural gas is produced from natural gas fields, and must be processed thoroughly before it can be used by consumers. The world’s largest natural gas reserves are located in Russia, with significant reserves spread throughout the Middle East as well.

Unlike crude oil, natural gas is difficult and expensive to transport, so it remains largely a regional commodity. Whereas a significant portion of oil consumed in the U.S. is delivered from the Middle East, trans-Atlantic pipelines are impractical due to natural gas’ low density, and the vast majority of natural gas used in the U.S. comes from various North American sources.

How Natural Gas ETFs Work

Due to the expenses and logistical difficulties associated with transporting and physically storing natural gas, ETFs offering exposure to this commodity do so through investing in futures contracts and other gas-focused financial instruments. The United States Natural Gas Fund (UNG) seeks to reflect changes in the price futures contracts on natural gas traded on the NYMEX. UNG generally invests in near month contracts until such futures are within two weeks of expiration, at which point it begins rolling its holdings over into second month contracts.

Many investors get into natural gas ETFs thinking that these funds will closely track the spot price of the commodity. But because natural gas ETFs gain their exposure through futures contracts, their performance will often deviate from spot prices, sometimes significantly.

ETFdb Pro members can learn more in our Oil & Gas ETFdb Category Report (if you’re not a Pro member yet, you can sign up for a free trial or learn more here).

Regulatory Environment

Natural gas ETFs (UNG in particular) have perhaps become too popular for their own good. As a $100 million fund, UNG controlled a relatively small portion of the natural gas futures market. But when the fund’s assets swelled to more than $4 billion earlier this year, regulators began to take notice. The Commodity Futures Trading Commission (CFTC) has held a series of hearings to determine the role UNG (and other ETFs tracking “commodities of finite supply) is distorting market prices and contributing to excessive speculation.

As UNG waits for the CFTC to establish positions limits on futures contracts, it has turned to other financial instruments offering exposure to natural gas contracts, primarily over-the-counter swaps. While this strategy is a creative solution to the position limits problem, it introduces a slew of new risk factors (not to mention a significant reduction in transparency).

Price Fundamentals

Although it seems they are often overshadowed by regulatory factors, fundamental supply and demand factors do indeed play a role in the prices of natural gas ETFs. Over the last year, supplies have increased steadily as massive new discoveries and improved extraction techniques have increased production rates. At the same time, demand has plummeted as a slowdown in the manufacturing sector and relatively mild weather ate into gas usage. Natural gas storage recently approached capacity, pushing prices to their lowest level in years.

But there are plenty of reasons why natural gas may be due for a comeback. An economic recovery is clearly underway, and if it proves sustainable (which is far from certain), manufacturing activity is sure to pick up. Texas oil tycoon T. Boone Pickens has been actively promoting a plan to lessen dependence on foreign oil that involves embracing natural gas alternatives for automobiles. And earlier this week, Qatar Airlines flew the first commercial jet running on natural gas on a flight from London to Doha.

Complex Investment

As natural gas prices have dropped to their lowest level in decades, investors betting on an inevitable rebound prices have jumped into these funds hoping to make a quick profit. While products like UNG and GAZ are among the best options for investors looking to gain exposure to natural gas prices, they’re not perfect vehicles. Far from it in fact. The complexities of futures investing and the uncertain regulatory environment make natural gas funds a risky bet on a number of levels. So before you jump in, make sure you’ve done your homework.

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Disclosure: No positions at time of writing.