There is growing outrage and/or interest (depending on your point of view) in the impact that the United States Natural Gas Fund (UNG) is having on futures prices for NYMEX natural gas. Cramer ranted it about it today. Both the Wall Street Journal and the Financial Times have written about it extensively. You can find the WSJ article here. However we really recommend reading the postings at FTAlphaville.com, which explain some of the dynamics surrounding the UNG and its influence on natural gas futures prices.

Trading volume in the UNG has absolutely exploded. Since June 1st the UNG has traded 57.5 million shares on average daily -- twice normal volume. Options activity in the UNG has sky-rocketed. The total NAV of the UNG has jumped from $670 million in February to more than $4.0 billion as of yesterday’s close. In the words of the immortal Vince Lombardi:

The United States Natural Gas Fund (in Theory)

The United States Natural Gas Fund was organized as a limited partnership on September 11, 2006 and commenced investment operations on April 18, 2007. The fund is managed by the United States Commodity Funds LLC, the same organization that runs the USO, USL, UGA among other well known energy related ETFs. The net assets of the UNG consist primarily of investments in futures contracts for natural gas, but also can include other types of crude oil, heating oil, gasoline, and other petroleum-based fuels that are traded on the NYMEX, ICE Futures or other U.S. and foreign exchanges. The objective of the UNG is to have the percentage change in the funds’ net asset value (NAV) reflect the changes in percentage terms of the spot price of natural gas delivered at the Henry Hub, Louisiana, as measured by the change in the price of the front-month natural gas futures contract traded on NYMEX.

Overall, the principals of the Fund “endeavor” to manage the UNG’s investment portfolio so that the average daily change in the NAV for any 30-day period is within 10% +/- of the average daily change in the price of the front month natural gas futures contract. Mechanically speaking, the UNG invests in the front-month futures contract up until two-weeks prior to expiration, at which point the fund conducts a four-day roll when it will sell its positions in the front month futures contract and invest in the next month’s futures contract in increments of 25%. The timing of the roll forward is disclosed publicly as are the UNG’s futures positions, which you can find here.

For the UNG, Theory Doesn’t Match Reality -- Contango’s Impact

The good news for the managers of the UNG is that the average daily tracking error for the NAV of the fund compared to the benchmark futures contract since inception is only 0.823%, well within the 10% goal. The bad news is that the performance of the UNG has had huge variance compared to the spot price of natural gas (typically tightly correlated to the front-month futures contract). For example, an investment in the UNG from 4/18/07 to 12/31/07 returned -28%, while the spot price of natural gas decreased by only 1%. In 2008, the NAV of the UNG declined by 41%, while the spot price of natural gas only decreased 25%. Not too impressive. The underperformance of the UNG relative to natural gas can be contributed to contango in the natural gas futures curve. Contango, more or less, implies an upward sloping futures curve. Inherently purchasing a higher priced futures contract during the UNG’s roll-forward results in a lower number of total contracts owned by the fund. Whereas there is normally convergence in the price of the front-month futures contract and the following month as expiration approaches, holders of the UNG do not benefit from that because the roll forward occurs two weeks prior to expiration. The folks at FT Alphaville explain contango’s impact on the UNG’s roll-forward process well.

If Ever There Was A Market Where Size Is the Enemy of Performance It Would Be Natural Gas

Despite its critical role in electricity generation and industrial production in this country, the natural gas market can be notoriously illiquid. Historically, the market has been dominated by a handful of large institutional firms, typically a combination of hedge funds and energy companies. Even with today’s lofty volume in the UNG, there were only 370 trades in the NYMEX July 2009 natural gas contract yesterday. Based on yesterday’s closing price the value of one July 2009 (the front-month) NYMEX natural gas futures contract is $42,500. According to NYMEX the open interest in the July 2009 natural gas futures contract stands at 64,035, which implies a total value of contracts outstanding of $2.7 billion. The UNG discloses its positions on the NYMEX and ICE exchanges on a daily basis. The table below outlines the open interest in natural gas futures contracts for the next 12-months and the UNG’s current holdings (click on chart for full image).

Source: NYMEX, the United States Natural Gas Fund

Now we truly have a strange situation. The NAV of the UNG as of 6/17/09 was just over $4.0 billion, the total value of the front month open interest in natural gas is now just above $2.7 billion. How can this work? Well for now, the UNG has been investing a greater amount in ICE natural gas futures contracts and increasing its swaps exposure. This is shaping up to become a real mess. The UNG has grown too large to fulfill all of its trading needs on the NYMEX, which for all intents and purposes was its original mandate. Clearly, the UNG has created “un-natural” demand for natural gas futures. In order to prevent one individual or institution from cornering the natural gas market, NYMEX has established accountability levels and position limits on futures contracts. The current accountability levels stand at 6,000 contracts for one single month and 12,000 contracts for all-months. Any investor or individual that eclipses these levels will be subject to greater scrutiny. We’re not quite sure what that means from an enforcement perspective, but the NYMEX is in a very difficult situation: Curtail the growth in the number of contracts the UNG can hold and the NAV could spiral in directions unforeseen or let the UNG grow and dominant the direction of natural gas prices.

We’re not sure how quickly this situation will resolve itself, but the rules of the game for valuing natural gas have clearly changed. As the UNG issues more shares, it seems possible that natural gas futures prices could spike higher. We have recommended getting long natural gas in a pair trade against a short position in oil here and here. The good news is that the price of natural gas has increased 26.2% since our recommendation. The bad news is that it has underperformed light sweet crude oil by 12.8%. Obviously the trade did not work, even if it helped identify that natural gas was cheap relative to historical standards. We still find natural gas FUNDAMENTALLY compelling, but we recommend everyone step aside until the situation with the UNG resolves itself.

One more issue to consider, the United States Commodity Funds LLC has filed to create an ETF that will track the 12-month futures strip of natural gas (similar to the USL, which tracks the 12-month futures strip of crude oil). We shudder to think how this could impact the shape of the futures curve, particularly in the less liquid outer months. One would think NYMEX, the SEC, or the CFTC would address the situation before things spiral further out of control.

As always, please act accordingly…