US Natural Gas Fund (ETF) Stops Issuing New Shares

The US Natural Gas ETF called UNG announced it was suspending the issuance of new shares.

As of July 7, 2009, UNG issued all of the remaining outstanding units to its Authorized Purchasers. As a result of these issuances, UNG will temporarily suspend the issuance of additional Creation Baskets until the SEC declares effective the registration statement on Form S-3 (333-159772) which was initially filed on June 5, 2009 and registers an additional 1,000,000,000 units. This registration statement is currently subject to review and comment by the SEC, the Financial Regulatory Industry Association (“FINRA”) and the National Futures Association (“NFA”).

Whether this suspension of new issues is temporary as stated or of a more permanent nature one cannot know for sure. But it does raise several questions worth answering.

• What effect will this have on the commodity?
  Answer: lower prices
• How will this affect the tracking relationship between UNG and Nat Gas?
  Answer: most likely it will trade like a closed end fund
• What about the Contango?
  Answer: less contango
• What are the implications to the ETF and commodity industry?
  Answer: the honeymoon is over

What effect will this have on the commodity?

Commodity ETFs were created in response to increased demand from the retail sector for commodity based vehicles in which they could invest. They provide a way for smaller investors to participate in the commodity markets without “worrying” about margin calls associated with trading the bigger physical contracts listed on the commodity exchanges. They are an attempt by Wall Street Investment banks to brand a previously unbrandable product, a finite commodity that is in the public domain. In a sense, Stock Exchanges and IBs essentially were securitizing commodities and listing them.

This is all well and good. There was a demand at the retail level and the commodity exchanges were unable to accommodate it. Entrepreneurial firms filled the need. The net result was a significant increase in incremental commodity demand from the public. Since most public participants play solely from the long side, their net effect on the markets have been bullish. The issuance of new shares (called Creation Baskets) is accompanied by purchases of the physical commodity. Without this retail business, there is one less buyer of Nat Gas and the overall effect is bearish on the product.

Conclusion: Absent all other factors in the commodity markets, Nat Gas will decline with less investor interest.

How will this affect the tracking relationship between UNG and Nat Gas?

If new-share issuance is permanently ended, then UNG will exhibit much of the behavior of a Closed End Fund (CEF). These vehicles rarely trade at the same price as their NAV. When they trade higher, it is almost always due to pent-up incremental demand and a lack of alternate choices to gain access to the underlying asset, as was the case for Emerging Market CEFs in 2008. In short, their assets are hot investment items and the CEF is the only vehicle for getting into the asset.

More often CEFs trade lower than their NAV. This can be for many reasons. The most theorized is that a CEF’s discount is a comment on management’s ability and the fees the fund charges. Basically, it can be deduced that CEFs trade at a discount because the market is efficient. While open-end funds do not because they are forced to trade at NAV. Why these discounts are not arbitraged out of the market is something that has been debated for years to no good consensus.

Conclusion: UNG price will fluctuate above and below the NAV of its portfolio. In a secular bull market for commodities (with good salesmanship) it will trade at a premium. In a disinvestment period, it will trade at a discount. There may also be short squeezes as shares are retired.

What about the Contango?

A lack of incremental retail investor interest is bearish for the commodity itself. It also follows that less open interest continually rolling over its position is bearish for the contango in that commodity. With less committed longs, there are less longs rolling over. This translates to a smaller discount of the prompt future to the second month future. Smaller open interest translates to less of a distortion during roll over periods. What is also of interest is the effect on the professional trading community.

Conclusion: UNG’s effect on the market contango will diminish over time and it will lessen.

Rollover Arbitrage

Securitization is one of the tools in which Wall Street produces profits. An early successful attempt at doing this in commodities was the GSCI. Clients of Goldman Sachs could buy a basket of commodities in private transactions and participate in commodity markets with minimal hassle. Buyers never had to rollover their expiring futures, Goldman did that for them. The GSCI was a huge success with Goldman clients in part because of this low maintenance quality. But as the GSCI grew in terms of open interest, so did its effect on the markets it was long.

The bylaws of the GSCI mandated that the positions had to be rolled over during a 5 day period. This more effectively systematized the fund’s management and made it less susceptible to rogue trading decisions. This automation made it clear what investors were getting into and made for an easier marketing pitch. What it also did, was remove much of the tactical value a trader adds in not telegraphing what he intends to do. So, the market always knew what the GSCI had in its poker hand, and it always knew when they would fold.

Knowing that the GSCI had to roll over a massive long position, traders would begin to position themselves to take advantage of that just prior to the actual roll-over. There were several ways they could do so, but the simplest was to simply put on the position that Goldman would be executing and hope that when the GSCI rolled over, they would be able to exit the trade at a better price. For example:

The GSCI fund is long front month futures. Next week, it will have to roll these into the second month to maintain its position and not have to take delivery. A hedge fund or local might sell the front month and buy the second month in a spread. A few days later, GSCI does the same thing, but because it has significant size, and must liquidate in a small time frame, it inevitably distorts the contango for a short period of time. The local hopefully takes a small profit.

This was not without risk to the local or hedge fund. It assumed several things. It assumed that the GSCI client base would not be liquidating its positions. It assumed that there were no other physical market effects that offset the roll, like a refinery fire or a war. It also assumed that Goldman was powerless to protect itself and its clients. Goldman was not powerless and did things to help mitigate the rollover risk, but there was almost always someone playing this in some way. Usually, the arb backfired when too many people were front running the roll-over and created an “over subscription” effect.

The UNG Roll

The same type of arbitrage happens in UNG and other commodity based ETFs. The fund manager has to roll his Natural Gas position. Professionals position themselves in anticipation of the event. They short the spread, play the UNG directly against the Nat Gas future or initiate some other cash-and-carry type position. These strategies all have term-structure risk and are not manipulation. But in the end, it is the public that suffers, even as they are the ones who are buying the commodity. Limited fungibility and captive order flows create what is essentially a regulatory arbitrage opportunity.

• Limited fungibility: professionals with balance sheets can play both markets, individuals cannot
• Captive Flows: UNG must roll, and in doing so it creates a potential distortion in the financial carry from front to second month expirations.

This ends up being a tax on the individual investor because of the uneven playing field. Cross regulatory conflicts and securitizing a finite commodity create the environment for systemic risk. Open-end ETFs are essentially derivatives of their respective commodities. As derivatives, their market cap could actually grow to be bigger than the above ground supply of the commodity to which they are tied.

As the public’s appetite for commodity ETFs grows their capital flows distort and make more volatile the actual price of the commodity in reference to its supply and demand fundamentals.

Conclusion: by effectively converting the UNG to a closed-end fund, rollover arbitrage will become a much riskier play. The mechanical nature of the UNG rollover will continue to exist. But if no new shares are created and existing shares begin to be retired, then the risks associated with this trade will increase.

What is next?

We suspect UNG has gone closed-end to preemptively address political issues with commodity speculation. We believe the fund’s next step is to get its open interest down as a percentage of Natural Gas. Once management decides what percentage of open interest is acceptable (or allowed) it will more than likely retire shares (and sell Nat Gas) in orderly fashion to get to those levels. Perhaps new shares would be issued when open interest gets under a certain level.
But in their current state, ETFs with mechanical rollovers distort the carry and storage aspect of commodities. This adversely affects the fundamentals of the commodity. Because money can move faster that it takes to build new storage facilities, the contango never rebalances itself with new buyers. Finally, it serves as a “Contango Tax” on the long term owner of an ETF and the retail public in general. ETFs are trading vehicles, not investment vehicles.

Reality Check

UNG has not converted to closed end. They merely suspended the creation of baskets. They have also filed for a billion new shares. So it stands to reason that they will begin creating new baskets at some point in the near future. Practically speaking, if there is demand for these securities then they will be issued. And for those people who think that this product and others like it may be a political football, we say this: if the SEC says stop creating new shares, this product will just pack up and go list itself in another country.