Barchart.com ETF Research
Natural Gas ETPs – Exposure to Natural Gas Prices Is Not An Easy Fix
ETF Research written by the Barchart.com ETF Research Team
Last updated: October 5, 2010
Table of Contents
Natural gas is a major global commodity. Natural gas supplies the fuel for 21.3% of global electricity generation, making it the second largest source behind coal at 41%, according to the International Energy Agency’s “Key World Energy Statistics” booklet (link). Aside from electricity generation, natural gas is also supplied directly to businesses and consumers for heating, cooling, and cooking. Natural gas accounts for 21.1% of overall global energy usage, placing it third behind oil at 33% and coal at 27%. The United States is the world’s largest producer of natural gas followed closely by Russia. Japan, Germany and the United States are the largest importers of natural gas.
The natural gas and crude oil markets are driven by very different fundamental supply/demand factors. Although natural gas and crude oil are both energy commodities, natural gas can be even more volatile than crude oil and the two markets have shown a correlation of only 0.24 from 1991-2010 based on monthly returns, as seen in Figure 1. Due to the low correlation and the big difference in supply/demand factors, we suggest that investors may want to consider separate investments in the two sectors rather than lumping their crude oil and natural gas exposure together in one investment vehicle.
Figure 1: Spot Natural Gas versus Crude Oil Prices (live chart)
As with crude oil and other commodity ETPs, investors need to be very aware of the major impact that an upward sloping futures curve (which is called “contango”) can have on a natural gas ETP. An upward sloping futures curve means that the futures contracts that expire farther out into the future are trading at a higher price than the futures contracts that expire sooner. There has been an outcry about the very poor performance of natural gas ETPs in the past two years when the natural gas market has been in a steep contango. A Bloomberg article goes so far as to refer to the U.S. Natural Gas Fund (UNG) as a “widow maker” because it has performed so poorly relative to natural gas prices over the past two years. The underperformance is not due to a so-called “rigged market” as some disappointed investors believe, but rather to the predictable outcome of a product whose performance is hurt badly when the futures market is in a steep contango. Contango is simply a function of the market expecting higher natural gas futures prices in the future and is not caused by a “rigged” market.
We fully explained the impact of the futures curve on commodity ETPs in our report, “Commodity Exchange-Trade Product (ETP) Performance and the Importance of the Futures Curve and Contango.” Investors need to understand that natural gas ETPs will not move one-for-one with spot natural gas prices because the shape of the futures curve will have a major impact on the performance of the natural gas ETP.
Figure 2: Natural Gas Spot Prices versus Futures Spreads
Figure 2 illustrates spot natural gas prices versus the futures curve as represented by the 1-2 and 1-12 futures spreads. The red line in the lower panel of Figure 2 shows the spread of the first (front-month) natural gas futures contract minus the second-month natural gas futures contract. The green line in the lower panel of Figure 2 shows the spread of the first futures contract minus the twelfth futures contract (which is one year out). When these spreads are negative, the front month contract is trading below the deferred contract and the market is in “contango.” When these spreads are positive, the front month contract is trading at a higher price than the deferred month contract and the market is in “backwardation.”
Figure 2 illustrates how the natural gas market fluctuates between contango and backwardation fairly often. Since 2006, the natural gas market has mainly been in contango with the deferred months trading at a higher price than the front months. However, when natural gas prices in mid-2008 ran up to more than $12 per mmBtu, the natural gas market moved to backwardation, with the market expecting lower prices in the future.
Figure 3 illustrates how the two natural gas ETPs with the longest history (UNG and GAZ) have severely underperformed the spot natural gas price over the past several years when the natural gas futures market has mainly been in contango and have particularly underperformed over the past year. This underperformance is mainly due to the steep contango curve.
Figure 3: Natural Gas Commodity ETP Performance versus Spot Natural Gas Prices (live chart)
Figure 3 illustrates that natural gas ETPs are only appropriate for investors who understand roll yields and are prepared to make a bet based on both the direction of natural gas prices and the roll yield. These products are not for the average investor, who is better advised to consider going directly into the futures market for a shorter-term natural gas play or to buy an ETF that holds the stocks of natural gas companies, or to stay away from the natural gas futures market altogether.
The following is a brief description of the three natural gas commodity ETPs.
United States Natural Gas Fund LP ETF (UNG) – UNG is by far the largest natural gas ETP with a massive $2.5 billion in assets under management as of September 2010. UNG is also the oldest ETP in the sector, having been launched in April 2007. UGN rolls forward in the front-month futures contract. As an example, UNG on September 22, 2010 held (1) 11,760 November 2010 CME/Nymex Natural Gas Futures (NG) worth $482 million, (2) 28,440 November 2010 CME/Nymex Natural Gas Futures (NN) worth $291 million, (3) 56,325 November 2010 ICE LOT Natural Gas Cleared Swaps worth $577 million, and (4) over-the-counter swaps worth $1.2 billion (link to UNG holdings).
iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN (GAZ) – GAZ was launched in October 2007 and has $132 million in assets as of September 2010. The ETN is an unsecured debt obligation of Barclays Bank PLC, which currently carries credit ratings of AA- by S&P and Aa3 by Moody’s. The iPath ETN is based on the Dow Jones-UBS Natural Gas Subindex Total Return, which is a subindex of the Dow Jones-UBS Commodity Index Total Return index. The DJ-UBS commodity index and its sub-indexes all follow the rule of rolling forward in the front-month futures contracts, thus causing potentially large performance problems when the futures curve is in contango.
United States 12-month Natural Gas Fund LP ETF (UNL) – UNL was launched in November 2009 and has yet to gain much traction with only $36 million in assets under management. Like its cousin in the oil market, the United States 12-month Oil Fund LP (USL), UNL spreads its position across the first twelve months of natural gas futures contracts. This diversification can reduce the negative impact of contango, although it certainly does not eliminate the impact.
Like their petroleum counterparts, we do not recommend the natural gas commodity ETPs for the average investor. The products should only be utilized by investors who specifically want to bet on both the direction of spot natural gas prices and the roll yield. Nevertheless, for investors who want to press ahead anyway, we like UNL better than UNG because UNL spreads its position across the first twelve futures months, thus reducing contango effects. However, a caveat with UNL is that it has only $36 million in assets under management, which is below our suggestion that investors only invest in ETPs with assets above $50 million. We would advise against GAZ since it is an ETN and since it rolls forward in the front-month contract.
Figure 4: United States 12-month Natural Gas Fund (UNL) versus United States Natural Gas Fund (UNG) (live chart)
Figure 4 illustrates the performance of UNL versus UNG over the past year. The chart shows that UNL’s performance relative to UNG has been spotty. This again highlights the fact that the trading of these instruments is tricky because of the big and variable impact of the roll yield.
We should add that UNG is potentially facing some serious regulatory problems, even to the extent that it may eventually be forced to switch to a different structure or even shut down. UNG holds a huge number of front-month futures contracts and over-the-counter swaps and the Commodity Futures Trading Commission (CFTC) has been threatening to force the ETP commodity funds to reduce their positions. In fact, UNG in 2009 temporarily stopped issuing new shares due to uncertainty about CFTC regulation. To try to stay below the CFTC’s radar, UNG has started buying over-the-counter swaps rather than futures contracts in order to reduce its futures position and to stay below CFTC position limits. However, the CFTC is preparing to bring swaps under its regulatory jurisdiction as well. For these reasons, in addition to the contango problems, we advise against buying UNG unless an investor has a very specific play in mind regarding spot natural gas prices and the roll yield and keeps a close eye on the regulatory situation.
Another problem with UNG is that the fund that is holding a massive quantity of $1.2 billion in over-the-counter swaps. While futures contracts are very safe because the trades are guaranteed by the futures clearing merchants (FCMs) and by a triple-A rated clearing corporation, over-the-counter swaps are much riskier because they depend on the credit rating of the counter-party and have no independent triple-A rated clearing corporation providing a backup guarantee. This adds a layer of risk to UNG that is not widely recognized.
Given the problems with natural gas ETPs, there is the potentially attractive alternative of investing in an ETP that tracks the stocks of natural gas companies. These companies have some correlation to natural gas prices because they typically own natural gas reserves and their unit sales and EPS figures go up and down with natural gas prices. Most natural gas companies also have the advantage of paying dividends to investors.
The First Trust ISE-Revere Natural Gas Index Fund ETF (FCG) is the largest natural gas equity ETF. FCG has a hefty $339 million in assets under management and has a fairly long history back to May 2007. The stocks in the index include companies that receive a substantial portion of their revenue from the exploration and production of natural gas. Stock candidates for the index are also screened by stock performance variables (such as P/E and ROE) as well as by statistical factors in order to optimize the performance of the index and to ensure the index has significant correlation to the price of natural gas, according to the product’s sales literature. The top 10 holdings in the fund at present are as follows (see the latest “Top 10 Holding” figures at Barchart’s profile for FCG):
Figure 5: First Trust ISE-Revere Natural Gas ETF (FCG) versus Spot Natural Gas and the United States Natural Gas Fund ETF (UNG) (live chart)
As Figure 5 illustrates, FCG shows a stronger correlation with natural gas prices than does the United States Natural Gas Fund ETF (UNG). FCG underperformed spot natural gas prices from late 2007 through early 2009, as did the United States Natural Gas Fund ETF (UNG). However, FCG took off starting in early 2009 and performed well relative to spot natural gas and particularly well relative to UNG.
Figure 6: ISE-Revere Natural Gas ETF (FCG) vs Spot Natural Gas Prices
Figure 6 overlays the ISE-Revere Natural Gas ETF (FCG) against spot natural gas prices in the upper panel. The lower panel shows the 60-day rolling correlation between the two series, which fluctuates between a moderately-strong 0.50 and a slightly negative correlation. The correlation between FCG and spot natural gas prices since the ETF’s inception in May 2007 is only 0.11. This indicates that an investor is not getting much direct exposure to natural gas prices by investing in FCG. We ran some correlation figures between some of the stock components in FCG and found that none of the individual stocks in the ETF have a high correlation with natural gas prices. Nevertheless, for investors who are bullish on natural gas, investing in FCG or the underlying natural gas companies provides a way to participate in both upside price movement in natural gas prices and the unit sales growth of the industry.
UBS E-Tracs Alerian Natural Gas MLP Index ETN (MLPG) – This ETN, backed by UBS AG, has only $10 million in assets under management, which means it falls well below our recommended $50 million minimum for investment consideration. Still, the concept of this ETN provides an interesting way to play natural gas. This ETN tracks the Alerian Natural Gas MLP Index, which is an equal-weighed composite of the 15 largest natural gas infrastructure Master Limited Partnerships (MLP) by market capitalization. Investors in the fund receive a quarterly coupon payment linked to the cash distributions paid by the underlying MLP companies. A Master Limited Partnership (MLP) is a limited partnership that trades on a stock exchange. The companies in the index “earn the majority of their cash flow from the transportation, storage, and processing of natural gas and natural gas liquids,” and the fund “provides investors with a benchmark for the infrastructure component of the natural gas industry,” according to the company’s sales literature. This fund is not designed to give exposure to natural gas prices, but it should benefit substantially if natural gas continues to grow as a primary energy source in the U.S., as we expect. Rather than investing in the ETN, investors might consider investing directly one or more of the underlying constituent companies, which include companies such as Copano Energy LLC (CPNO), Spectra Energy Partners LP (SEP), Targa Resources Partners LP (NGLS), Duncan Energy Partners LP (NGLS), and others.