How The U.S. Natural Gas ETF (UNG) Lost 23% In August

The United States Natural Gas Fund (NYSE:UNG) is truly one-of-a-kind, not only as a commodity ETP but as an investment vehicle in general. Since its inception in April 2007, (NYSE:UNG) has lost almost 90% of its value, steadily declining as natural gas prices tumbled and the nuances of a futures-based investment strategy ate into the asset base. That sort of track record would have killed a mutual fund long ago, and seemingly should have made investors think twice about natural gas as an investable asset. Yet (NYSE:UNG) remains tremendously popular; total assets now stand at around $2.5 billion, and the average daily trading volume tops 20 million shares.

Even by UNG’s standards, August was an abysmal month. The fund lost about 23% of its value, or nearly 1% for every trading day during the month. For a commodity that is widely used in both industrial and residential applications–and one that seems likely to be a major component of the energy puzzle in the U.S.–such a steep drop in a relatively short period of time is difficult to fathom.

The impact of contangoed futures markets on UNG’s returns has been well documented. Although spot natural gas prices finished 2009 roughly where they began UNG sunk by more than 55% that year, due primarily to the “roll yield” incurred each month as the fund sold off expiring contracts and purchased longer-dated futures [also see our Closer Look At The Contango Killer Commodity ETF].

Contango certainly contributed to UNG’s dismal August–October futures are currently trading at a discount of about 7% to November contracts, which are currently priced another 7% below those for December delivery–but the slope of the futures curve certainly not the primary culprit. UNG’s recent freefall is more attributable to four fundamental factors:

1. Hurricane Duds

Several months ago, several major weather agencies were predicting an extremely active hurricane season: by some estimates 14 to 20 named storms were expected to develop with four to six “major hurricanes.” That led many to speculate that supply disruptions could be ahead–essentially a repeat of 2005, when Katrina and Rita devastated the Gulf Coast and natural gas prices skyrocketed.

Hurricane season certainly isn’t over yet, but the intense activity many were predicting has so far been a no-show. Weather-related supply shortages haven’t occurred, and the “hurricane premium” priced into natural gas futures has steadily evaporated. If anything, hurricanes could push natural gas prices lower in coming weeks. Hurricane Earl is threatening the East Coast, steering clear of key gas-producing regions in the Gulf of Mexico. Tropical Storm Fiona seems likely to follow a similar path, and the two could potentially cause power outages in densely-populated areas and sap demand for gas-fired electricity [see UNG’s Insurmountable Obstacle].

2. Dismal U.S. Outlook

Perhaps the biggest blow to UNG has come from a deteriorating outlook for the U.S. economy. With job creation essentially non-existent and a material downward revision to second quarter GDP, investors have soured on U.S. equities in recent weeks; the Dow Jones Industrial Average turned in its worst August performance in nearly a decade.

Although natural gas and crude oil are similar in many ways, there are some key differences between these commodities. Whereas crude is regularly transported around the world from oil-rich regions to net importers, natural gas is largely a local commodity. That means that gas delivered at the Henry Hub is used primarily within the U.S., and that natural gas prices are somewhat immune to economic strength or weakness elsewhere in the world.

So even as the outlook for the U.S. oil usage sags, the emerging markets of the world continue to prop up demand. That’s not the case for the natural gas underlying UNG’s holdings; there is no opportunity for other regions of the world to make up for weakness in the U.S. [also see Natural Gas ETFs: Investing In The Fuel Of The Future]

3. Massive Discoveries Continue

Even if demand for natural gas surges–and some of the legislation making its way through Washington makes that seem likely–it will have a hard time keeping up with a rapidly-expanding global supply of the fuel. The last month has seen several massive discoveries of natural gas, including previously uncovered fields in Israel and Australia.

As mentioned above, natural gas is primarily a local commodity, so huge new discoveries around the world don’t necessarily translate into a flooding of the U.S. market. But as LNG technology continues to develop, that may be changing. The discovery of natural gas in regions not known as traditional energy hot spots has convinced investors that supplies will be ample for the foreseeable future, adding further downward pressure to prices [see UNG’s Insurmountable Obstacle]

4. Heat Wave Doesn’t Pay Off

Just as a mild hurricane season has disappointed natural gas investors, the recent summer heat wave also failed to live up to expectations. With a streak of scorching temperatures throughout the country in late July, investors expected that a surge in air conditioning usage would put a nice dent into gas inventories, or at least temper the traditional summertime build-up.

But natural gas inventories continued to climb throughout August, as expectations for the “heat wave drawdown” proved to be too aggressive. Moreover, as temperatures across the U.S. have dropped in recent weeks, gas prices have pulled back sharply from a recent peak above $5, recently trading even below the $4 threshold.

Where From Here?

As summer draws to a close, catalysts for a rebound in natural gas prices are nowhere to be found. Inventories remain well above historical levels, and the regulatory environment is yet to throw up a major obstacle to continued production. Don’t be too surprised if UNG continues to set new record lows in coming months [also read Natural Gas ETFs: Seven Ways To Play].

Written By Michael Johnston From ETF Database  

ETF Database is committed to giving our audience, consisting of both active traders and buy-and-hold investors, information that, to our knowledge, is truthful and non-biased.

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