The problem with commodity ETFs | FT Alphaville

The problem with commodity ETFs

The day ahead of the United States Natural Gas (UNG) ETF’s futures roll from the July to August contract, Olivier Jakob of Petromatrix — who has inadvertently become a bit of a lone crusader in the mission to expose the influence of exchange traded funds on commodity markets — presents an impressive summary of the story so far.

His primary observation:

ETFs [based]on Commodity Futures have a basic design flaw in that they are open-ended fund that invest in assets (Futures) that are close-ended (either due to CFTC regulation or due to lack of liquidity). This is a major contradiction that is at the source of market dysfunctions.

At issue currently is the rampant growth of the UNG, the natural gas positions of which have doubled since last month’s roll. This growth, by the way, is eerily similar to that experienced by the ETF’s sister fund, the USO, earlier this year – the background to which you can read about here.

In the UNG’s case, however, the growth has been so large that in order to avoid a regulatory clampdown on its futures positions the fund managers have been forced into the world of over-the-counter swaps. Accordingly, the fund’s swap positions are now 2.6 times larger than its future ones.

To give some perspective, if the fund was to put all that money into the futures market, Jakob calculates it would be equal to occupying 78 per cent of  open interest in the July Nymex contract. Meanwhile, the holding of large swap positions goes against the fund’s mandate as outlined in its prospectus.

As Jakob explains (our emphasis):

The UNG prospectus states that the UNG will “invest primarily in Futures Contracts”. The total net assets of the UNG have now reached 3.5 byn usd which if it was invested in the front Futures month (as implied by the prospectus) would amount to 92’879 Nymex Natural Gas Futures contract; this compares to an Open Interest on the prompt Futures contract (July) of 119’100 contracts. This would amount to 78% of the July Futures Open Interest. To have one entity directly holding such a share of the Futures Open Interest would probably not be tolerated by the CFTC.

So, to keep the regulators at bay, the fund appears to have delved deep into the swap market after reaching a futures position equal to about 21 per cent of the open interest in July Nymex Natural Gas futures.

From the perspective of ETF investors, this might be a concern because swaps are not simple instruments. They are the domain of physical market specialists and are open to much more complex pricing procedures based on cumulative averages. It’s not as simple as tracking a front-month future price.

What’s more, looking at the subsequent swap build-up, another trend emerges. The UNG seems to have stopped investing in July Nymex Henry Hub swaps after reaching a position equal to 33 per cent of open interest.  Since May 20th all new investments have been flowing specifically into ICE swaps instead. As ICE does not publish swap open interest, however, it is impossible to ascertain the fund’s relative position here.

The strangest thing of all, however,  is the context of the fund’s build-up. Just like with the USO, it comes mostly in a declining price-environment and a contango shaped curve. Contango, as explained here, poses a challenge to funds whose methodologies oblige them to keep rolling futures contracts into ascending prices to maintain their positions. Simply stated, every roll registers a loss.

If you consider that it was only when the USO began to shed  positions that the price of crude eerily began to rise, there may indeed be something to it.  In fact, even now, the more the USO sheds, the more the price of crude seems to rise and the contango flatten more. As Jakob explains:

The USO holdings of WTI Futures peaked at 96’500 contracts on the 19th of February. On the 24th of February, Platts revealed that the CFTC was contacting the USO in view of their holdings in WTI Futures and the CFTC then made a public statement about the same on the 27th of February. Since then the WTI holdings in WTI have continuously been reduced.

The fact the UNG is building positions into a heavy contango curve therefore strikes us as somewhat illogical. What’s more, the more it builds, the firmer the contango appears to be getting, as this chart from Jakob shows:

UNG & contango - Petromatrix

For context, this was the respective case with the USO (notice how the contango began to abate just as the fund began to shed positions):

USO & contango - Petromatrix

So, how damaging can all this be to the market? According to Jakob, at the roll everything will depend on the hedging of the UNG’s swap counterparties, but he leans toward advising clients to avoid the market completely until the roll is finished. As he explains:

If the counterparties that have sold the swaps to the UNG have offset their shorts with another exposure unrelated to the UNG then the rolling risk for the Futures is primarily on the 21% of the Futures Open Interest that the UNG is holding and that should be manageable without too great a risk of a market disruption.

However, if the counterparties that have sold the swaps to the UNG are barely covering in the Futures market then the UNG could still indirectly own a worrying share of the Futures Open Interest which in theory could be as high as 78%. Given this uncertainty we would rather play it from the safe side and reduce the NatGas exposure for the next four days. Furthermore, this will be the first time that the UNG rolls such a position (double the size as a month ago) which means that the managers of the UNG have no practical experience in the rolling of such a large position and of its potential market impact.

Causation or correlation with UNG aside, one thing is sure – some very peculiar things have been going on with the price of natural gas since the fund began to inflate. People are beginning to wonder why.

Related links:
Strange things still afoot in natural gas
– FT Alphaville
Commodity ETF investors move significantly into natural gas
– FT Alphaville
Super-natural gas
– FT Alphaville
Anything but therm in the US
– FT Alphaville
A self propelled pyramid?
-FT Alphaville
How contango affects oil ETFs  – FT Alphaville