This ETF Is Headed Straight To Zero

With a 1 percent year-to-date loss, natural gas hasn't done anything special this year, but it hasn't done bad either. The commodity, dubbed the "widow maker" by many because of how volatile it is, has had an uncharacteristically well-behaved 2015 thus far, fluctuating in a tight band between $2.50/mmbtu to $3 during the first half of the year.

Still, you don't have to go back far to see volatility on the natural gas charts, with prices down sharply from where they were just one year ago, when they were in the $4 to $5 range. A surge in production and a much milder 2014/2015 winter compared with the one before have pressured natural gas significantly. 

Natural Gas

Source: Bloomberg
 

Are prices headed even lower, or is now the time to buy?

Prices Cheap

From a historical perspective, natural gas prices are pretty cheap. The last time they traded at these levels was for a brief period in 2012, following an exceptionally warm winter. Before that, they traded around these levels in 2009 during the worst of the financial crisis.

History suggests that if natural gas prices fall below $3, they don't stay there for long.

That fact hasn't gone unnoticed by bargain-hunting natural gas traders. Since the start of the year, hundreds of millions of dollars have flowed into natural gas exchange-traded products.

UGAZ Overtaking UNG
But unlike past downturns, the money isn't going into the top ETF in the space, the United States Natural Gas Fund (UNG | C-100); it’s going into a leveraged competitor, the VelocityShares 3x Long Natural Gas ETN (UGAZ).

During the first 6 1/2 months of the year, UGAZ has attracted $328 million in capital. The ETN now boasts $597 million in total assets, just a hair below UNG's $620 million. At the same time, volume has exploded, averaging nearly 60 million shares per day over the past month compared with about 1.5 million shares at the same time last year.

Clearly, active traders have taken a strong interest in UGAZ, hoping to profit from any bounce in natural gas prices.

Unfortunately, those big bets in UGAZ have yet to pay off. Since the start of the year, the ETP is down a whopping 45 percent. From a year ago, it's down a stunning 88 percent.

UGAZ, UNG, Natural Gas Futures 1-Year Performance

Source: Bloomberg
 

At this point, it's worth reiterating that UGAZ is a leveraged product. That makes it substantially more volatile than nonleveraged ETPs such as UNG. These types of products attempt to capture the returns of an underlying index, but add leverage to the mix in order to multiply returns. In the case of UGAZ, returns are expected to be three times that of the S&P GSCI Natural Gas Excess Return Index (this index essentially mirrors the front-month roll strategy of UNG).

The Perils Of Leverage

Leveraged ETPs typically rebalance daily. That means they are good at delivering three times the return on any given day. However, over a longer period of time, performance tends to lag due to the combined effects of volatility and compounding.

A simple illustration of this performance drag is to consider a hypothetical example where natural gas is trading at $5/mmbtu, while UGAZ trades at $5/share. If natural gas prices increase by 10 percent to $5.50, UGAZ would increase by 30 percent to $6.50.

If on the next day natural gas fell back to where it was at $5, a loss of about 9.1 percent, UGAZ would drop by about 27.3 percent, putting its share price at $4.72, 6 percent below where it was the previous day, even though natural gas prices were the same.

The more volatile the movements in underlying natural gas prices, the bigger the performance drag for UGAZ. That's not even considering the additional drag from contango.

Roll Costs

Like most commodity markets where it's not practical to buy the physical product, the primary way that ETPs get their natural gas exposure is through the futures market. UGAZ is no exception.

Though it's an exchange-traded note and it doesn't directly hold futures, it behaves in the same way. The biggest issue with commodity futures is that they expire, and ETPs must continuously roll into subsequent futures contracts to maintain exposure to the underlying commodity. When the futures curve is upward-sloping and longer-dated contracts cost more than near-term contracts, it's called contango, and it takes a bite out of returns.

For example, say an ETP is holding front-month August natural gas contracts priced at $5/mmbtu. It can hold those contracts for a month. However, as expiration approaches, it must roll into the second-month September contract, unless it wants to take physical delivery of the commodity, which obviously isn't practical.

In the natural gas market, contango is typical. That means that the September contracts are likely to be more expensive than the expiring August contracts. In our hypothetical example, the September contracts are $5.10/mmbtu. At the higher price, the ETP is able to buy fewer natural gas contracts than it previously had; in this case, 2 percent less. That "roll cost" adds up over time, compounding the aforementioned issues with leverage.

Source: Bloomberg
 

UGAZ Headed To Zero

The combined effects of leverage and contango make it so UGAZ is almost certain to underperform natural gas prices significantly. If natural gas prices decline from here, UGAZ will fall faster―much faster. On the other hand, if natural gas prices rise, UGAZ is only likely to outperform for very short periods of time.

A case in point is the VelocityShares 3x Inverse Natural Gas ETN (DGAZ), UGAZ's bearish counterpart. Though natural gas prices are down 31 percent from a year ago, DGAZ is only up 46 percent. That's a far cry from the three times inverse exposure that a buyer of DGAZ may have expected.

But of course, as we explained earlier, the three times performance is only promised for any given day, not longer periods, and certainly not a year.

Ultimately, the path of least resistance for UGAZ (and DGAZ) is down. The ETP has been a money pit, sucking in $1.2 billion out of investors over the past year and leaving them with less than $600 million today. Yet traders continue to pile in, seduced by the big daily swings in prices and the hope that natural gas may quickly rebound.

While there's certainly the case to be made that natural gas may move higher from here―particularly over the next several years―UGAZ isn't the right product to play that potential trend.

Financial Evaporation

It does what it's supposed to do, capturing daily swings in natural gas prices with leverage. But the decay factors that we discussed will eat into the share price, pushing UGAZ ever lower. In fact, while it may sound like hyperbole, the ETN is on an inexorable path toward zero.

While all leveraged products tend to lose value over time, the three times leverage is particularly nefarious in how fast it takes its toll.

UGAZ is certainly not the only product to feel the negative effects of leverage. The popular VelocityShares Daily 2x VIX Short-Term ETN (TVIX) is down 99.99 percent from its highs, yet there is still $243 million in assets betting that first- and second-month VIX future positions will rise. Likewise, the VelocityShares 3x Long Crude Oil ETN (UWTI) is another name in the down-90-percent-plus club, yet has still attracted more than $1.2 billion in inflows during the past year.

The Bottom Line

Leveraged exchanged-traded products (ETFs and ETNS) aren't a scam; they do what they are designed to do. However, too many investors and traders buy them without a clear understanding of what they're getting into.

These products are perfect for short-term traders looking to capture quick day-to-day swings. For anyone else with a longer time horizon, they are to be avoided at all costs.