UNG goes OTC | FT Alphaville

UNG goes OTC

Bloomberg reports the United States Natural Gas exchange traded-fund, which has been buying Nymex and ICE natural gas swaps since at least the beginning of June, has now been pushed into the world of OTC bilateral swaps.

As the agency writes:

July 24 (Bloomberg) — United States Natural Gas Fund, the world’s largest fund in the commodity, bought an off-market gas swap for the first time in a sign that it has outgrown the main markets for fuel futures and swaps.      The $4.4-billion fund purchased a $250 million bilateral swap that isn’t subject to the size limits imposed by the New York Mercantile Exchange, where the fund holds $480-million worth of natural gas futures and swaps.

This is hugely significant due to the nature of the OTC market, its liquidity and also its positioning out of regulatory reach. For an ETF like the UNG, this also generates important questions about transparency, and counterparty risk. In an OTC bilateral trade, no exchange-based liquidity pool can come to your rescue in the event of default.

As Olivier Jakob of Petromatrix notes:

The UNG is playing cat-and-mouse with the regulators but in the process the investors in the UNG are now starting to have an additional risk which is the default risk on the OTC Bilateral Swaps. The more the UNG moves to OTC Bilateral Swaps, the more it will also be exposed to the risk of being squeezed.

The above, interestingly, comes as the CFTC prepares to start hearings on  how to address position limits and exemptions from such limits in the energy market this week. Among those pressing for exemptions are United States Commodity Funds, the owners of the UNG and USO commodity ETFs, as well as  Goldman Sachs among others.

In a note to FT Alphaville, the chief investment officer of the US Commodity Funds wrote:

“The 8-K recently filed by UNG, as well as the earlier 8-K filed by USO, make clear that the actual data showing the Fund’s buying and selling of futures contracts do NOT in any way support the theory that they had anything to do with the rise in oil prices in early 2008 and early 2009, or the rise in natural gas prices in early 2008.

This despite the claims of so-called “experts” to the contrary who, in their statements in recent months, always seem long on theory, and very short on hard data, when making their claims. I would hope that in the upcoming hearings by the CFTC, that the Commissioners would take the opportunity, when faced by such claims by any of the witnesses, to demand that the witnesses back up their statements with facts. Witnesses need to explain how ETFs that were sellers when prices were rising, and buyers when prices were falling, can actual be driving the price of commodities! Most of these claims have as much validity as claims that the attack on Pearl Harbor was the work of Sweden! This will hopefully help put this nonsense to rest once and for all.

He also provided the following graphic to make his point:

Natural Gas Fund positions - UNG

But, as we have always maintained at FT Alphaville, the issue here is not one of effect on price. In fac,  it is the counter-intuitive nature of position buildups into a descending market that strikes us as odd. In effect that means that as other financial institutions like hedge funds and pension funds are pulling out of commodities, investors in ETFs are piling in.

Jakob believes, if anything, this reflects the propensity of passive funds like the UNG to add fuel to a descending momentum due to their impact on contango via their regimented rolling system. As he writes (our emphasis):

The problem of the UNG and USO is that they have grown too big for the underlying market they are supposed to cover. And when one market participant has such a dominating position then the market stops to function properly as traders do not anymore price the fundamentals but price the expectations of movement in the position of the dominating market participant. Sometimes this will push the market artificially higher, sometimes this will push the market artificially lower. It is the word “artificially” that counts not the words “higher” or “lower”.

Related links:
The problem with commodity ETFs
– FT Alphaville
Strange things still afoot in natural gas
– FT Alphaville
Commodity ETF investors move significantly into natural gas
– FT Alphaville
A self propelled pyramid?
-FT Alphaville