More fun with commodity ETFs

The natural gas trade is getting crowded - very crowded.

Driven by the seemingly perpetual optimism that the price of natural gas can't go any lower when nearly every other commodity price is soaring, traders and investors alike have piled into the giant United States Natural Gas Fund, LP ETF (NYSEArca:UNG) in recent months, a development that has become, ironically, a bit problematic.

The first-of-its-kind ETF that holds only natural gas futures, launched just over two years ago now with average daily trading volume of over 22 million shares and boasting net assets of anywhere between $2.2 billion and $4.5 billion, depending upon where you look, seems about ready to run up against its limit in issuing shares.

This sets up all sorts of interesting possibilities.

Unlike commodity ETNs (exchange traded notes) that simply track futures markets using credit instruments, commodity ETFs (exchange trade funds) normally buy and hold futures contracts for the underlying commodity which, not only has an impact on the futures market itself, but has the added complexity of running up against real limits, self-imposed or otherwise.

This report in the Wall Street Journal has all the details:

One of the hottest investments on Wall Street may have gotten too big for its own good.

With investors betting on rising gas prices, assets in U.S. Natural Gas Fund recently swelled to almost $3.7 billion from about $670 million in February, even sparking fears it could be disrupting the futures market.

Now the popular exchange-traded fund is days away from another potential problem: Funds that hold commodities typically face stiff restrictions on the number of shares they can issue to meet investor demand, and U.S. Natural Gas is running out fast. Securities and Exchange Commission filings show managers want to increase the number of shares available nearly tenfold. But such requests can take weeks and there isn't any telling when the SEC will act.

If the fund can't issue enough shares to meet investor demand, its shares could begin trading at prices higher than the underlying value of their holdings, breaking a key promise ETFs make to investors and possibly influencing prices in the natural-gas futures markets.

This should be interesting to watch - both the response from the SEC and the futures market. Natural gas is unique in the energy commodities group, not only underperforming crude oil and distilled products lately, but doing so by a wide margin as shown below.
Of course, since last Friday, prices have moved quickly back up above the $4 per MMBtu mark to $4.21 for a gain of almost ten percent.

Here's what the ETF looks like over the last two years:
An apparent belief that the plethora of opportunities to buy high and sell low will not continue seems to have attracted millions of new investors over just the last couple months.

###

To learn more about investing in natural resources using commonly traded ETFs, stocks, and mutual funds, see this description at Iacono Research. Or, sign up for a free trial.

Full Disclosure: No position in UNG