Things looking ugly for the UNG | FT Alphaville

Things looking ugly for the UNG

Last week, prominent oil-industry financier Matt Simmons, CEO of Simmons & Company International, weighed in on the UNG/commodity exchange-traded-fund (ETF) debate by posting the following missive to a handful of recipients:

How on earth can a tiny firm amass 30% of nat. gas contracts, with funding jumping from $727 million to $4.5 billion in three months as nat. gas prices tank? Why would so many little investors plunge into buying natural gas contract exposure when every new article over past three months predicted gas gluts and prices soon to plunge to $1 to $2 dollars?

Simmons’ email includes some pretty frothy allegations, which we are not minded to repeat here. But his core point is undeniably valid, especially when demand for this particular ETF still remains high despite torrid fundamentals for natgas.

We have speculated here  on whether or not contango in the underlying nat-gas contract  opened up a particularly enticing arbitrage opportunity between the net asset value (NAV) of the fund, the price of the shares and/or the underlying natgas contracts for either authorised participants (including “obvious names” like Bank of America and Goldman Sachs, according to UNG boss John Hyland) or professional statistical-arbitrage investors.

Before people remind us that arbitrage is the whole point of ETF methodology, however, we would stress that what we are implying is that there is some alternative additional arbitrage at play here that goes beyond the obvious NAV/price reversion.

Whatever the reasoning, what’s certain is that traditional buy-and-hold investors may be facing an increasingly explosive situation for their invested funds. While the UNG was granted the right last week by the SEC to issue more creation units — having run out of shares on account of its recent popularity — it has decided to waive that opportunity despite its NAV/price deviation running to unpalatable levels of more than 11 per cent.

Its justification was concern that federal regulators would prevent it from investing in natural gas.

Of course, allowing a NAV/price deviation of 11 per cent to persist erodes the UNG’s entire raison d’etre as an ETF. Olivier Jakob of Petromatrix sums up the situation nicely (our emphasis):

We have been warning about the UNG for a long time but we will increase the risk warning one notch higher due to extreme divergence between the share price of the UNG and its Net Asset Value. The UNG is currently trading at +11.32% over N.A.V whereas ETF’s are supposed to trade as close as possible to 0% of NAV.

The S.E.C has taken the outrageous decision to allow the UNG to issue more shares but the UNG is resisting doing that (for now) due to the CFTC breathing on its neck. By pushing the shares at such a premium to NAV the market is in essence trying to force the UNG to issue more shares and we can observe that trading Volume on the UNG has increased following the SEC decision.

If the UNG does not issue more share than the UNG will get one step closer to implosion. The shares of the UNG have now 11.3% of hot air into them and any asset manager not warning his client that he is investing in hot air should get ready for upcoming lawsuits. The implosion/liquidation risk is getting greater by the day as the premium to NAV increase.

If and when that happens it could have some ripple effect in WTI as well, as concerns will then be mounting on the sustainability of the USO or other single commodity ETF’s. Our only recommendations can be: avoid at all cost investing in the UNG, keep minimum long exposure to NatGas Futures (due the UNG liquidation risk) and have any NatGas exposure further away than the October contract.

Meanwhile, here is that NAV/price deviation, as charted by Petromatrix:

UNG NAV/price deviation - Petromatrix

Also, the effect on the overall market is not insubstantial. As Jakob notes the front time-spread (the difference between the September and October contract) has now collapsed in a pattern not dissimilar to that noted in WTI crude earlier this year when the UNG’s sister fund, the USO, had grown to its peak size.

Related links:
Natgas, literally under pressure
– FT Alphaville
A self propelled pyramid? -FT Alphaville
More weirdness at the UNG
– FT Alphaville