NEW YORK (
) -- As I review the most important developments in the ETF industry during 2009, two stories stand out prominently: natural gas and the trading of leveraged funds.
What's more, these stories continue to evolve and may prove crucial in 2010 as well.
Here is a look at some of the natural gas articles that received the most interest from readers. Later this week, we'll review some of my most popular 2009 articles on leveraged funds.
Natural Gas ETF 'Taxed' by Delay
Originally posted 07/14/09 03:14 PM EDT
In the latest chapter of the
United States Natural Gas ETF
saga, the fund has begun to trade at a noticeable premium to its actual value, forcing investors to "pay up" to get a hold of shares.
UNG closed at a 2.56% premium to net asset value (NAV). This predictable move is a result of a regulatory hang-up in the fund's creation process that defines the very nature of ETFs.
Unlike mutual funds or closed end funds, ETFs have a transparent portfolio. Each day, investors can find out exactly what is in the basket of stocks that make up each fund. Baskets generally include securities or futures and a cash amount. The price of an ETF should be close to its NAV, since it is possible to determine what the fund is worth while the contents of its basket are trading.
In the normal course of events, several factors can cause an ETF to deviate from its NAV. That may occur if the contents of the ETF basket are not trading at the same time as the ETF -- e.g., the fund contains Chinese equities that trade only on Chinese exchanges during Chinese exchange hours, not 9:30 a.m. ET to 4 p.m. ET -- or if some component of the basket is halted during normal trading. A fund with a low number of buyers and sellers, and consequently a low trading volume, can also deviate from NAV.
In the case of UNG, however, the entire pricing mechanism has been thrown off by a halt in the creation process. When an ETF first appears on the market, an approved market maker will create units of the fund to sell to customers. As demand for the fund increases, market makers will create additional units to sell to investors.
Picture a UNG approved market maker as a kid who wants to have a lemonade stand. On his first day, he will mix up a batch of lemonade after he anticipates how much lemonade he will sell. He will probably consider factors like the weather and how busy his street is. As awareness of the lemonade business grows and demand increases, he will have to make bigger and bigger batches each day to meet demand if he doesn't want to raise the price.
UNG has become like a lemonade stand on a super highway of demand. In anticipation of the volume that the fund would generate each day, designated market makers have had to make bigger and bigger batches of the fund. On July 7, the SEC cut off the supply of lemonade. In a regulatory filing issued last Tuesday, UNG had to suspend issuing new shares while it waits to see if it can create 1 billion new units. UNG had originally been approved to create 200 million units.
In the meantime, investors are still thirsty for shares of UNG, driving the price of the existing UNG shares above their NAV. While some investors may not care about the price increase and just want to get into the fund, it is important to understand that this method of pricing runs against the "spirit" of ETFs. The eventual approval of more units is very likely, and this move will drop the price of UNG until it is back in line with NAV.
As I have mentioned in
creation difficulties are not the only problem with UNG.
to invest in natural gas ), and fortunately there is another ETF that offers investors exposure. The
First Trust ISE-Revere Natural Gas
tracks a basket of natural gas companies. Investors interested in natural gas exposure can use FCG to gain access to the industry.
Just one month before UNG creation was halted on June 7, the U.S. Commodity Futures Trading Commission announced that it would hold hearings this summer to consider imposing position limits for "all commodities of finite supply." See
Any change in these regulations could further impact the pricing of UNG or even force UNG's issuer to redesign the fund to meet requirements. In the meantime, investors should stay clear of UNG until the dust settles.
Natural Gas Heads for Super Contango
Originally posted 08/28/09 08:19 AM EDT
Late last year and into early 2009, West Texas Intermediate crude prices entered what was dubbed "super contango." The spot price for oil was far below the futures price, guaranteeing a huge profit for anyone who bought and stored barrels of oil and sold an offsetting futures contract.
The reason for the extremely low price was because storage was maxed out at the Cushing, Okla., delivery point. Previously high prices led to a demand reduction that was exacerbated by the global financial panic. Oil was "too cheap," but there was nowhere to store it and that caused prices to crater. Eventually, investors filled supertankers with oil, parked them offshore, demand picked up and prices recovered.
Natural gas may be headed into super contango as well. The spot and near-month futures contracts sell for less than $3 per million BTUs, but October 2010 futures can be sold for $6. Buy the gas today, store it and next year earn a 100% profit less storage fees. One problem --where are you going to store it?
Natural gas storage is 18% above five-year averages and, according to the Energy Information Administration, regional storage may max out. Unlike oil, natural gas is much more of a regional energy source because it still mostly moves from producer to consumer via pipelines. Liquefied natural gas may change that in the future. Local storage facilities may run out of space in another month or two, and then the gas has nowhere to go -- unlike the price, which will rapidly drop.
Many people think it's easy to switch between natural gas and oil, but in fact they serve different markets: 70% of crude oil goes towards transportation, whereas natural gas is split three ways between residential & commercial, industrial and electric generation demand. Switching from one to the other is a
and most of the switches have been made.
The international nature of crude oil means if people in Ulan Batur demand more oil, the price may change in New York. But a natural gas shortage in Mongolia will not raise American prices because there's no easy means to transport it. There were major discoveries of natural gas last year and New York Governor David Patterson is pushing to open up the Marcellus shale to drilling, with environmental concerns taking a backseat to the need for tax revenue.
On top of that, renewable energy currently is aimed at electricity generation, not transportation (though that may also change depending on the popularity of electric cars).
Natural gas has abundant natural reserves, excessive supply and reduced demand and is a competitive threat -- it was one of the hottest ETFs in the past three months, based on money flows.
As I warned almost two months ago, the fundamentals pointed to
. I was right and prices have fallen. I've also warned against investing in
U.S. Natural Gas
UNG became a slow-moving target in the futures market that allowed savvy speculators to front-run its monthly contract roll. It already created an exacerbated the near-month contango and cost investors money each time it rolled. Now due to
concern over pending regulatory changes
, UNG ceased issuing new shares and trades at a whopping premium of 17%. The
iPath Natural Gas ETN
doesn't offer much advantage; it had an 8% premium at close yesterday.
Ironically, if we see a final super-contango cratering of UNG, it may create the conditions for the next bull market, but that could take months to years to play out, however, and depends on multiple factors. I've recommended
First Trust ISE-Revere Natural Gas
, which holds the stocks of producers and has outperformed UNG since March, as a better way to play natural gas if that's your desire. But unless another Katrina rips through the Gulf region, the outlook for natural gas prices is grim.
A Natural Gas ETF to Play Contango
Originally posted 08/31/09 01:04 PM EDT
JPMorgan Alerian MLP Index ETN
offers investors exchange traded exposure to the natural gas marketplace without the problems of
United States Natural Gas
Although AMJ is less of a "pure play" on natural gas prices than UNG or even
First Trust ISE-Revere Natural Gas
, it's much more predictable over the long term.
AMJ's investors gain access to the natural gas market through the stocks of companies that store and transport natural gas, many of which are structured as Master Limited Partnerships. While this exchange traded product comes with the risks of exchange traded notes, it is large and liquid, allowing investors to trade in and out of the fund with relative ease.
The companies that AMJ tracks are well diversified businesses involved in natural gas pipeline and storage. According to the fund's fact sheet, the top five holdings in the fund are
Kinder Morgan Energy Partners
Enterprise Products Partners
Plains All American Pipeline
Energy Transfer Partners
Energy Transfer Equity
These firms are a sort of "tax collector" as natural gas passes through the system, taking a toll even when natural gas prices are low. Natural gas is currently in huge supply at low prices. Eventually this price discrepancy, along with cold weather, hurricanes, or other typical drivers, will push consumers toward natural gas.
UNG's structure aims to track natural gas prices at the risk of
, while AMJ tracks MLP's at the risk of issuer J.P. Morgan. AMJ is a collection of debt notes, rather than equity, which exposes the fund to the credit risk of its issuer. AMJ was originally launched by Bear Stearns under the symbol BSR, but changed its symbol when J.P. Morgan took over and relaunched the index on June 2, 2009.
Rather than having to roll futures contracts month to month like UNG, AMJ is designed for investors seeking income. The MLPs that AMJ tracks are designed to pass on earnings to investors through their dividends. AMJ's quarterly dividend amounted to 43.6 cents in August. This payout is similar to the dividend that BSR paid in the past, setting AMJ up to yield around 7%.
ETNs are structured for savvy investors, because of the added risk. This risk, however, pales in comparison to the problems over at UNG. As UNG fights to
and expand, it is exposing investors to increasingly risky derivatives. AMJ is much more suitable for conservative investors looking to make income over time.
Another added benefit for AMJ investors is the tax structure of the fund. MLPs pass their income through to investors, which results in a K-1. Since AMJ is an ETN, it issues a 1099, allowing investors to avoid the K-1. Do-it-yourself tax preparers will appreciate the difference between these two forms.
While UNG, FCG and AMJ offer unique perspectives on the natural gas marketplace, UNG tracks spot prices, FCG tracks producers and AMJ tracks MLPs. Of these funds, AMJ is the most appropriate for savvy income investors. The "toll booth" firms that underlie AMJ will continue to pick off the flow of natural gas and continue to be indispensable participants in the energy marketplace.
-- Written by Don Dion in Williamstown, Mass.
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At the time of publication, Dion did not have positions in any equities mentioned in this story.
Don Dion is president and founder of
, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.
Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.