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The Wild, Wild West of Natural Gas Trading
By Dian L. Chu, Economic Forecasts & Opinions
In my last article, I discussed two of the major factors to this week’s run-up in natural gas - Operation Flow Orders (OFOs) and pre-configured stop orders being hit. Here, I’d like to take a look at some of the other concurrent distortions in the natural gas market.
UNG Rolling Effect
After a nearly year-long run, the United Natural Gas Fund's (UNG) assets shot past $4.5 billion at one point. Just in a two-week period in May, the ETF's assets doubled despite lagging performance (UNG share price has retreated about 55% this year.) The fund has been rumored at times to hold as much as 80% of open interest in the NYMEX front-month contract.
As reported by FT.com, this is a rollover week for UNG. The fund also has just become an active buyer of fresh futures again. Essentially, the UNG roll is another reason for the natural gas surge this week on lack of market fundamental support.
On many days, UNG has dominated in the natural gas market, but a victim of its size and structure, UNG has also become a large and predictable player that has to roll because it has no capability of taking the contract to expiry.
The fund’s swap counterparties know just when and how much it has to roll; and everything will depend on the hedging of counterparties. Accordingly, UNG usually fails to fetch a competitive price and the contango between the front and second month increases at each roll. For this reason, the fund will almost always underperform the natural gas futures it is supposed to track (Fig. 1).
NYMEX Natgas Bubble
What's more, UNG said it plans to restart new issues on Sep. 28, which is also the day that the October contract expires. Trading wise, this not only means that the Oct/Nov contango could still widen during the roll this week, but also that during October there could be another upside volatility to natural gas outright prices as the UNG could come back to buy outright November contracts.
Compounding the “UNG rolling effect” is that CME Group (CME) just announced much more aggressive position limits on futures contracts, and this may have prompted some short-covering. Meanwhile, Goldman Sachs (GS) recently predicted that natural gas prices will triple by this winter, while a speaker at a Barclays energy conference said natural gas is the ‘trade of the year.’ With natural gas at the confluence of all these concurrent events distorting the already volatile marekt, a NYMEX natgas bubble as described by the Schork Report seems inevitable.
UNG Investment Risks
Though UNG has become a very popular vehicle for investors and traders to participate in the futures market, the fund has been trading at a sharp premium to its underlying net asset value (NAV) since Aug. 12, when it announced that it couldn't issue new shares because of limits on how many natural gas contracts it can buy.
The share was trading at a 16% premium to NAV on Aug. 21, but now that's down to around 4%. The premium along with the share price should continue to fall from now till the new shares get issued. As such, short interest for UNG surged 135% to 30.9 million shares in the two- week period ended Aug. 31 (Table 1).
In addition, UNG itself states there is no longer any predictability to when it feels like being in an issuing cycle and when it doesn’t. This predictability issue is noteworthy enough to earn a sell, sell, sell from Jim Cramer.
Caveat Emptor
Therefore, from all indications, retail investors dabbling in energy markets better take heed, the above being proof of just how complex and volatile the market can be. I would agree with Cramer’s call to sell if you bought UNG at a premium to its NAV before it drops even further. Meanwhile, new investors should stay away from UNG.
For now, the best way to play the natural gas market is probably buying natural gas producers such as Chesapeake Energy Corporation (CHK) and EOG Resources, INC. (EOG) on the dip. Since these producers typically all have aggressive hedging programs in place to protect future production, investors could still benefit from their market expertise without the complexity and risk as investing in UNG.
Dian L. Chu, Economic Forecasts & Opinions
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I'm sorry, but I call BS on the claim that the UNG Fund has held as much as 80% of the front-month futures contract. The position limit is 20,000 and I can tell you from actually meeting with a partner of the Fund, that they are currently BELOW the 20,000 limit.
Last time I checked, the open interest for the October contract was nearly 80,000 contracts. I find this article to be "tabloid" journalism to make such absurd claims!
2 Weeks ago the UNG roll is the easy sell, now it's the reason the market goes up? What explains today's rise? UNG roll over (yesterday), huge long trap yesterday on 3.800 touch to settle below 3.500 and then roll over and market up. Is the 3.778 settle today just more short covering (after everyone got their chance yesterday?)I tend to agree with this guy, but just remember there are alot of people who called 6 dollars when it was at 4, and alot of people who called 1 dollar when it was at 2.500. Again remember it's a future, so the price is for delivery at a point in time, much like an equity option. Nov is trading 88 cents above X. So if someone says prices up 20% by Oct (nov fut trading), if they don't go anywhere, they are still right.
Where do you get this data that UNG is 80% of the front month future? I know this is rumored but a significant amount of their holdings is in ICE swaps as well as bilateral swaps which do not have open interest available.
On another note its hard to believe that UNG trading the V/X spread size has caused the market to rally when we have seen V/X converge...
If GS says going up, you better start to believe it. I know the fundamentals suck, so is the economy. did you see how SPX is doing? It has NOTHING TO DO with the reality. GS says the SPX will be 1050 at the end of the year, it is 1050. Who the hell are you to argue with GS? GS is the only game in town.
Interesting dynamic in nat gas that is unfolding just like the steel trade of a few months ago. I look at CHK and XTO like X and NUE. CHK has marginally fewer gas reserves than XTO with markedly higher leverage. But in this junk rally leverage wins so CHK's equity vastly outperforms XTO's slow and steady.
Earlier this year steel was the hot trade. NUE has the best balance sheet in the steel industry and are exceedingly efficient producers. X produces marginally more steel than NUE but is grossly overleveraged. Sure enough NUE had a slow and steady march while X took a rocketship.
The point of all this exposition, chasing leveraged beta in this market goes much deeper than financials and can be used to aid stock picking as long as the junk rally continues. Of course ponzis being what they are, leverage is a double edged sword on any downturn.
Nat gas showing some possible bullish divergence on the weekly chart.
Market Trends:
http://www.zerohedge.com/forum/market-outlook
Natty investors/traders might consider FCG an etf that investment results that correspond generally to the price and yield of an equity index called the ISE-Revere Natural Gas Index.
Go back to CNBS. Buy UNG.
Great Article...but you know UNG posts it's rollover days on their website too so you don't need FT to find them.
good info
CME impossing trading limits because someone has 80% of the market ? What are they trying to do- run an orderly market- horse and stable door spring to mind.
Shame on NYMEX and ICE for not controlling Vitol when crude went to $147- .Still its only the consumer who gets raped.