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August 16, 2009

Natural Gas ETF Suspends New Shares - Are There Alternatives?

Dian L. Chu, 08/16/09

New Shares Suspension

United States Natural Gas Fund (UNG), the world’s largest natural gas ETF, will suspend offering new shares on concerns that federal regulators will keep it from investing in natural gas futures. This decision came after the fund won SEC approval to sell up to 1 billion new units, which would give the fund room to almost triple in size.

This move may keep the fund trading at an expanded premium to its underlying net asset value (NAV), making it more expensive for those retail investors who can only gain exposure to the gas futures market through the fund.

Under Regulatory Fire

In addition, sensing that regulation was imminent, UNG reallocated funds from futures to mostly over the counter ICE swaps. The halt of the new share issuance has broken the tie between NAV and market price, which essentially changed it into a closed-end fund. But the change to swaps alters the nature of the fund entirely. Due to the fact OTC market lacks liquidity, and it’s out of regulatory reach, this generates serious concerns about transparency, and counterparty risk for an ETF like UNG.

UNG is not the only ETF under fire. Leveraged funds such as Direxion Daily Financial Bull 3X (FAS) and Daily Financial Bear 3X (FAZ) as well as ProShares Ultra Short Real Estate (SRS) have also sparked the ire of regulators, skeptical of sales practices. A number of firms, including UBS (USB) and Ameriprise (AMP), have halted the sales of such products to their clients. The scrutiny of these funds has been led by the Financial Industry Regulatory Authority (FINRA).

The Basic Design Flaw

Fundamentally, all ETFs based on commodity futures have a basic design flaw in that they are open-ended funds that invest in futures that are close-ended. This is a major contradiction that is at the source of market dysfunctions.

It comes mostly in a declining price-environment and a contango curve. Contango poses a challenge to funds whose methodologies oblige them to keep rolling futures contracts to maintain their positions. So, with a contango futures curve, every roll registers a loss. UNG units are down about 46% this year, while NYMEX gas futures, which the fund is supposed to track, have fallen about 38% in the same period.

What’s Next for UNG?

Right now, UNG is in the middle of an overhaul and will not go down without a fight. Its rampant growth has been so large that in order to avoid a regulatory clampdown, its portfolio will most likely be shifting more into offshore energy exchanges and swaps. Another option is buying energy futures other than natural gas such as crude oil and gasoline. Whatever the fund decides spells trouble for investors, as the very essence of the fund is changing. Already a sophisticated strategy for even seasoned investors, UNG is about to become more complex.

Investment Alternatives

With new shares suspended, UNG still had the highest asset inflows of any ETF during the month of July, according to data published by Morningstar. However, it is best to stay away from UNG or other commodities ETFs until the regulatory dust settles.

As the near to medium term price momentum is likely to be on the crude oil side as compared to natural gas, investors should consider some of the oil-weighted independent exploration & production (E&P) companies. Almost all E&Ps have aggressive hedging programs in place since they do not have a refining/marketing arm like the major oil companies as natural hedges to their E&P operations. Therefore, investing in E&Ps with strong balance sheets and international portfolios would be a good hedge for existing UNG holders, or as new investments in lieu of crude oil and natural gas ETFs. Two such companies come to mind: XTO Energy (XTO) and Apache Corp (APA). There is also an ETF - SPDR Oil and Gas Exploration and Production (XOP) that could be a reasonable candidate for your portfolio.

Disclosure: No Positions
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Item Reviewed: Natural Gas ETF Suspends New Shares - Are There Alternatives? Rating: 5 Reviewed By: EconMatters