Tuesday, September 1, 2009

Larry's UNG dilemma

"CFTC is pushing small investors out of the commodities markets!" said Larry. Larry is a small investor who wanted to go long US natural gas and had in the past used "UNG" to do so. UNG is an ETF that is long US natural gas:
The investment [UNG] seeks to replicate the performance, net of expenses, of natural gas. The trust will invest in futures contracts on natural gas traded on the NYMEX that is the near month contract to expire. It is nondiversified.

UNG started trading at a premium to NAV recently, and Larry doesn't want to be the sucker who buys an ETF at a premium. But wait, ETFs (unlike closed-end funds) are not generally supposed to trade at a premium to NAV. From iShares:
With ETFs, Authorized Participants such as specialists on the exchange or institutional broker/dealers can create or redeem shares directly with the fund through an "in-kind" transfer mechanism. APs create ETF units by delivering a basket of securities to the fund equal to the current holdings of the ETF, plus a designated "cash component." In return, the APs receive a large block of ETF shares (typically 50,000 shares in the case of iShares Funds), which investors can then buy and sell in the secondary market.

This process also works in reverse, so if an investor wants to sell a large block of shares of an ETF and there seems to be limited liquidity in the secondary market, the APs can readily take them in and redeem them.

This constant exchange of the portfolio assets for shares of the ETF works to tighten any spread between where the fund trades and it's NAV. As demand increases, more shares are created, while if demand drops, shares are taken out of the market.

Now imagine a situation of increased demand (as is the case with UNG), but the fund can no longer accept "a basket of securities equal to the current holdings", because that basket is the NYMEX natural gas futures contract. UNG, worried about CFTC limiting it's ability to hold natural gas futures, stopped creating new shares (because as it grows it will need to buy more futures). With the supply and demand out of balance, UNG now trades at some 17% premium. UNG can eventually use TRS instead of futures, but it may take time to set that up (and the regulation around TRS remains unclear).

UNG and it's NAV

UNG is Larry's choice because it's quite liquid, but the premium he has to pay forces him to stay away. Larry of course could open a futures account, but futures commissions and minimums are significantly higher (value of a single nat gas futures contract is about $30K).

Of course the reason for this whole dilemma is that CFTC wants to stop Larry and his friends from "speculating" on natural gas markets. That's because speculation is bad and it drives up prices. Larry and his evil gang of speculators have driven prices up this year, but somehow the fundamentals of natural gas oversupply got in their way (with natural gas trading 50% down year-to-date). CFTC, we urge you, please stop Larry before it's too late.

Disclosure: no exposure to UNG

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