In compiling our linkfests it seems like we are noting the happenings in the natural gas market on a daily basis. There has been a great deal of chatter about not only the future prospects for natural gas prices but the controversy surrounding the increasingly popular United States Natural Gas Fund (UNG). What is clear is that is issue is not going away any time soon and is certainly not going to get any less complex.
So there really are two issues here running in parallel. What are the prospects for natural gas and how can an individual investor take advantage of them? We are admittedly not experts in natural gas, but many are making the case for natural gas becoming a more critical energy source in the United States for years to come. Indeed some have argued for a partial transition to natural gas for transportation in addition to its current uses. As pressures for cleaner energy sources rise, it seems logical that natural gas should be ascendent.
Admittedly this longer term bullish case has not exactly played out over the past year. Natural gas prices have been in pronounced downtrend with prices hitting new lows. However, the ratio of oil to natural gas has hit levels not seen since 1990, in short natural gas is cheap relative to oil. On the other hand given current higher than normal natural gas stockpiles the prospects for a seasonal rally seem dim.
Assuming you buy into the natural gas story how is an investor to take advantage of it? Unfortunately the most easily accessible vehicle, UNG, is a mess. Two issues, the growing size and influence of the fund and a parallel push by the CFTC to limit energy speculators have forced the fund to stop issuing shares. The fund is therefore now trading less like an ETP and more like a closed-end fund. Although there are some hints the fund may re-open.
In a recent Wall Street Journal article Brian Baskin discusses the issues facing investors in commodity ETFs and finishes up with this:
Investors shut out of ETFs would still have a few ways to track commodity prices, such as a major oil company like Exxon Mobil Corp. Shares of such companies usually, but not always, move with energy prices.
This statement glosses over the complexity facing investors who are seeking out proxies for natural gas. (We have discussed the topic of proxy investing a number of times including in regards to hedge funds.) For example, in the case of oil and oil stocks the relationship can (and often) gets out of kilter. Therefore trying to track oil prices with oil stocks induces tracking error.
Tracking error aside, there seem to be any number of proxies for natural gas. These include: integrated energy companies like the aforementioned Exxon Mobil (XOM), natural gas-focused exploration & production companies, offshore and onshore drillers and gas pipeline companies to name but a few. If the current situation drags on one could even envision companies coming up with more ways to play natural gas. While there may be a case for the aforementioned sectors, it takes more time and research effort to tease out the bullish case.
These potential proxies are not perfect and many would prefer to have UNG trading as it did prior to this controversy. Any one bullish on natural gas prices would prefer direct access to the commodity. Futures trades can do this directly by buying natural gas futures. Indeed there are e-mini natural gas futures that are more easily digestible for individual investors. Both of these options presuppose you trade futures.
This discussion does raise a public policy issue. There does seem to have been some pent-up demand for easy access to commodity markets. The popularity of commodity-tracking ETFs shows that the current regime is not serving smaller investors particularly well. The clear demarcation between the securities and futures markets seems to have shut out small investors from the futures markets. While there are some good reasons for this, it seems that investors want easier access to commodity exposure.
That is why a fund like UNG that hides the many complexities of futures trading arose. The complexities of futures are hidden in the returns of the underlying fund. Indeed it seems that many investors do not understand these many complexities. Whether this is a regulatory failure or a market failure is unclear.
There is some question whether an open-ended structure like an ETP is a viable one for commodities that are not readily storeable. For example in the case of gold and silver the ETFs by and large hold the underlying physical commodity. In the case of something like natural gas that is not really possible. Therefore a fund needs to deal in futures or directly deal in swaps. The challenge for the manager of UNG has their strategy for rolling their futures positions.
In short, everyone in the marketplace knows their strategy and they take the other side. David Merkel at the Aleph Blog has a proposal for better managing the risks inherent in this sort of fund. However any sort of solutions will come with some costs, including a lesser ability to track the underlying spot commodity. While we wait for some greater clarity on the future of UNG we also need to keep in mind the issues facing it going forward.
Sometimes using something like proxy investing can help profit from our investment theses, but in the case of natural gas it puts an investor in a bit of a quandary. Each potential natural gas proxy will likely induce tracking error. In short there is no perfect substitute for the underlying commodity. If you are long term bullish story on natural gas you want to garner the returns on the commodity. However in the short run, contango and the lack of easy access to natural gas prices make taking this position problematic.
While we have no opinion on the natural gas investment case ourselves, it seems that investors bullish on natural gas have two options. At the moment paying a sizable premium for an imperfect investment vehicle like UNG does not seem particularly attractive. Investors can therefore seek out some viable natural gas proxies that provide some measure of upside participation or simply wait it out. Of late waiting it out has served investors well price-wise and in the meantime a viable natural gas investment vehicle may (re-)emerge.
If you have gotten this far you should recognize that this issue is complex. That maybe the biggest lesson in all this. The ETF industry has taken a complex practice, commodity investing, and tried to make it simple. In doing so a number of issues have been swept under the rug, or in this case behind fund walls. There are some solid reasons why investors may want commodity exposure including portfolio diversification and access to ‘natural hedges.’ This demand aside, it is not entirely clear whether we currently have a good solution at hand.
*No position in any security mentioned herein.