The Wild, Wild West Of Natural Gas Trading

In my last article, I discussed two of the major factors to this week’s run-up in natural gas - Operation Flow Orders (OFOs) and pre-configured stop orders being hit. Here, I’d like to take a look at some of the other concurrent distortions in the natural gas market.

UNG Rolling Effect

After a nearly year-long run, the United Natural Gas Fund’s (UNG) assets shot past $4.5 billion at one point. Just in a two-week period in May, the ETF’s assets doubled despite lagging performance (UNG share price has retreated about 55% this year.) The fund has been rumored at times to hold as much as 80% of open interest in the NYMEX front-month contract.

As reported by FT.com, this is a rollover week for UNG. The fund also has just become an active buyer of fresh futures again. Essentially, the UNG roll is another reason for the natural gas surge this week on lack of market fundamental support.

On many days, UNG has dominated in the natural gas market, but a victim of its size and structure, UNG has also become a large and predictable player that has to roll because it has no capability of taking the contract to expiry.

The fund’s swap counterparties know just when and how much it has to roll; and everything will depend on the hedging of counterparties. Accordingly, UNG usually fails to fetch a competitive price and the contango between the front and second month increases at each roll. For this reason, the fund will almost always underperform the natural gas futures it is supposed to track (Fig. 1).

NYMEX Natgas Bubble

What’s more, UNG said it plans to restart new issues on Sep. 28, which is also the day that the October contract expires. Trading wise, this not only means that the Oct/Nov contango could still widen during the roll this week, but also that during October there could be another upside volatility to natural gas outright prices as the UNG could come back to buy outright November contracts.

Compounding the “UNG rolling effect” is that CME Group (CME) just announced much more aggressive position limits on futures contracts, and this may have prompted some short-covering. Meanwhile, Goldman Sachs (GS) recently predicted that natural gas prices will triple by this winter while a speaker at a Barclays energy conference said natural gas is the ‘trade of the year.’ With natural gas at the confluence of all these concurrent events distorting the already volatile marekt, a NYMEX natgas bubble as described by the Schork Report seems inevitable.

UNG Investment Risks

Though UNG has become a very popular vehicle for investors and traders to participate in the futures market, the fund has been trading at a sharp premium to its underlying net asset value (NAV) since Aug. 12, when it announced that it couldn’t issue new shares because of limits on how many natural gas contracts it can buy.

The share was trading at a 16% premium to NAV on Aug. 21, but now that’s down to around 4%. The premium along with the share price should continue to fall from now till the new shares get issued. As such, short interest for UNG surged 135% to 30.9 million shares in the two- week period ended Aug. 31 (Table 1).

In addition, UNG itself states there is no longer any predictability to when it feels like being in an issuing cycle and when it doesn’t. This predictability issue is noteworthy enough to earn a sell, sell, sell from Jim Cramer, the host of Mad Money on CNBC.

Caveat Emptor

Therefore, from all indications, retail investors dabbling in energy markets better take heed, the above being proof of just how complex and volatile the market can be. I would agree with Cramer’s call to sell if you bought UNG at a premium to its NAV before it drops even further. Meanwhile, new investors should stay away from UNG.

For now, the best way to play the natural gas market is probably buying natural gas producers such as Chesapeake Energy Corporation (CHK) and EOG Resources, Inc. (EOG) on the dip. Since these producers typically all have aggressive hedging programs in place to protect future production, investors could benefit from their market expertise without the complexity and risk as investing in UNG.

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Comment by Sergio L

2009-09-20 15:01:29

I must tell you, I invested a lot of money in UNG according to a newsletter writer named Steven Jon Kaplan who is the “author” of “True Contrarian”. I think he is a financial criminal for not disclosing the risks with UNG when I bought it 4 months ago with an average price of $14.7.
Lately he recommended to sell all UNG and to change it to the Canadian GAS-T or the American CYMGF (same thing ) because of the premiums. Indeed the last move was smart but it can not even cover my loses.
I see huge volume at the main fund for natural gas etf symbol FCG, if you take a look at it you will be amaized. I think Nat Gas is going to the sky. I will keep holding UNG. Your advise will be reworded. Sorry I do not have spell checker.
Thank you Sergio L

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Comment by Dian L. Chu

2009-09-20 16:43:52

Thanks for your comment. Best of luck to you.

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