Over The Limit?

August 27, 2009

With the US futures market regulator on the warpath, we ask whether the pricing problems affecting US commodity trackers could start to affect European issues as well.

Could the pricing problems that have affected US commodity trackers start to impact European issues as well?

A month ago the Chairman of the US futures markets regulator, the CFTC, struck a warlike note at the Commission’s first hearing on the functioning of the commodity markets. “Every option must be on the table,” Gary Gensler said. “I believe we must seriously consider setting strict position limits in the energy markets.” If set, such limits would “protect the American public,” Gensler continued.

Since then, uncertainty over the possible imposition of trading limits has caused the pricing of certain US commodity trackers to go haywire. On 12 August, the United States Natural Gas Fund (NYSE Arca: UNG), the world’s largest natural gas tracker fund, announced that it was suspending the issue of new shares, citing the likely imposition of position limits as the reason. UNG’s price swiftly rose to a double-digit premium over net asset value.

Nine days later, Barclays declared that it was “temporarily suspending” issuance of its iPath DJ-UBS Natural Gas exchange-traded notes (NYSE Arca: GAZ), without giving a specific reason, although it mentioned that the value of other iPath ETNs might be affected by “current market dynamics and ongoing regulatory review”. The iPath ETN’s price rose to a 6.5% premium over intrinsic value on the day of suspension, according to Bloomberg.

Similar steps have now also been taken by Deutsche Bank with its Powershares DB Crude Oil Double Long ETN (NYSE Arca: DXO), and by iShares with its iShares S&P GSCI Commodity Indexed Trust (NYSE Arca: GSG). The related news stories can be found on our sister site, IndexUniverse.com, here and here. DXO rose to a 1.5% premium to its indicative intraday value on the day of its suspension, while GSG closed at a 2.35% premium to NAV on 25 August, according to the iShares website.

According to Bloomberg, by 25 August the premiums on UNG and GAZ had risen to 15% and 12%, respectively, suggesting that the pricing problems are getting worse. That’s good news if you’re already invested in these natural gas trackers, but not so great if you’d like to gain exposure to the commodity or if you were attracted by ETFs’ vaunted ability to trade in line with the underlying asset value in the first place.

Yet the European versions of these instruments continue to act as if nothing has happened. According to data provided by London commodity specialist ETF Securities, its natural gas exchange-traded commodity (ETC) traded with a 0.1% average premium to the net asset value implied by front-month natural gas contracts last Friday (21 August), the same day that UNG traded at an average 14.2% premium to NAV.

Why have European energy tracker products so far managed to avoid the pricing problems faced by their US counterparts, and can this state of affairs continue?

According to Ted Hood, chief executive of ETF and ETC issuer Source, the key difference between the US energy trackers that have been affected and their European counterparts is that the US funds’ structure requires them to buy the commodity futures directly, whereas the energy ETCs offered in Europe by Source and ETF Securities purchase their commodity exposure from market counterparties, typically banks. The US energy funds – UNG and GAZ for example – are already acting as if they will be made subject to position limits themselves, whereas the European issuers can diversify their exposure through the use of multiple counterparties. How these counterparties then hedge themselves is a question for them rather than the ETC issuers.

Nik Bienkowski, chief operating officer at ETF Securities, explained that a typical commodity counterparty can offset the performance “promise” it gives to the ETC in a number of ways, whether through futures, options, the use of other securities or counterparties, or by netting the position off with an opposite exposure, perhaps from a client taking a different market view. “This gives our structure flexibility,” Bienkowski said.

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