The Future For UNG

September 25, 2009

The United States Natural Gas Fund will start issuing new shares again on Monday. What can investors expect to happen?


The United States Natural Gas Fund (NYSEArca: UNG) will begin issuing new shares on Monday, ending a three-month stretch in which the popular exchange-traded fund had capped the number of shares available to the public.

The fund shut down its so-called creation facility in June of this year. The reason, at first, was simple: A surge of assets had flooded into the fund, and UNG had simply run out of shares to issue. As a commodity pool, UNG must petition the Securities and Exchange Commission for the right to issue a set number of shares; when those shares run out, it must ask for more.

Typically, such requests are rubber-stamped by the commission. But in this case, the SEC sat on the appeal for more than two months. It never said why, but some people believe that the delay was due to mounting concerns about UNG’s massive size. With more than $4 billion in assets under management at the time, many thought (and still think) that UNG is distorting the market for near-month natural gas futures.

With the number of shares capped, UNG quickly traded to a premium above its net asset value, spending much of the summer trading at 2 to 4 percent above NAV.

The SEC finally relented in August, and granted UNG approval to issue more shares. But in a shocking turn of events, UNG demurred, citing concerns that the Commodity Futures Trading Commission was planning to issue strict new limits on how big a position a firm can have in the futures market.

“We just don't feel it's prudent to accept [new unit] creations and then attempt to use the money to purchase more natural gas products when we have a strong belief that the CFTC is going to mandate limits that would either cap us or force us to reduce our holdings," John Hyland, UNG's manager, told the Wall Street Journal at the time.

The move created a frenzy for UNG shares, driving the premium up above 20 percent at one point. Hyland tried to replace some of the fund’s positions in natural gas futures holdings with privately negotiated swap contracts offering exposure to natural gas?a move that would help UNG get around any future CFTC limits?but had limited success.

Twist On Creation Process

In mid-September, however, UNG filed a notice with the SEC stating its intention to reopen the fund for creations by Sept. 28. The new creation process, however, came with a twist. In the past, institutional investors called Authorized Participants (or APs) could create new shares of UNG simply by buying up the front-month futures contract and delivering it to the fund company in a one-for-one swap. Now, those investors must deliver privately negotiated swap contracts to enact the creations.

The twist is a clever switch for UNG. It needs privately negotiated swap contracts to get around any future CFTC limits, but it was having trouble finding them. Now, it’s letting the APs do the work, tasking them with putting the swaps in place in order to create new shares.

As soon as UNG announced its plan, the premium on UNG shares began to collapse, moving from more than 10 percent to approximately 2 percent as of yesterday. When the creation window actually opens on Monday, the premium should fall further.

Why? Because institutional investors can arbitrage the difference between the cost of negotiating private swap contracts for natural gas futures and the premium on UNG shares. These investors?the APs?can create as many shares of UNG as they want at fair market value, provided they can find the swap contracts to do so. They can then go and sell those shares into the public market and cash in on the difference. If UNG is trading at a 2 percent premium and swaps only cost 0.50 percent per year, for instance, the arbitrageurs can make an easy 1.5 percent profit.

What that means is that the premium for UNG shares?already down sharply from August?should fall further. Specifically, it should collapse to reflect more or less the cost of negotiating private swaps in the natural gas market, which appears to be less than 1 percent.

It’s not 100 percent sure that the new creation process will work as designed. UNG has the right to reject any creation offers that it doesn’t like, and most APs are probably not used to sourcing privately negotiated swap contracts in order to execute their arbitrage trades. But they are used to making money, and with a 2 percent premium on the table and huge volume in the fund, you can bet they are looking at this opportunity very, very closely.

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