Wednesday, January 6, 2010 12 comments ++[ CLICK TO COMMENT ]++

Worst non-leveraged ETF of the year: UNG

Commodity investors may know UNG as the ETF that tracks natural gas. Well, it apparently posted the worst return of any non-leveraged ETF last year. MarketWatch reports:

United States Natural Gas Fund lost almost 60% in 2009, but its difficulties went beyond falling prices for natural gas due to the poor economy and oversupply issues.

U.S. Natural Gas Fund, with assets of about $5 billion, was the worst-performing ETF in 2009 that doesn't use leverage. The natural-gas exchange-traded fund was off 56.5% for the year, while the SPDR S&P 500 ETF, which tracks U.S. large-cap stocks, gained 23.4%, according to FactSet Research.

Aside from the decline in natural-gas prices in 2009, the fund was also hit by a condition in futures markets known as "contango," in which the price of longer-dated futures contracts is higher than the spot price.

"Investors should be mindful that this fund invests in natural-gas futures and not the spot price of natural gas," wrote Morningstar's Paul Justice in his most recent analyst report on the ETF.

"This fund mostly invests in near-month futures contracts," he added. "As each month draws to a close, the fund rolls over to the next month's contract, and so forth. When the prices of those out-month contracts exceed the price of the near-month contract ... the fund loses money each time it rolls futures. That explains why this fund has oftentimes declined in value even as natural gas prices rose, as the natural gas futures market was in contango at that time."

Traders attempt to game the huge ETF by trying to jump ahead of its trades when it rolls into the near-month futures contract. Investors in the natural-gas ETF are hoping the long-anticipated rebound in prices plays out in 2010.

News to me is the following note about UNG being one of the best selling ETFs in 2009:

Despite its terrible performance, U.S. Natural Gas Fund was one of the best-selling ETFs in 2009.

According to the latest data available from the National Stock Exchange, the natural-gas ETF as of November had year-to-date net cash flows of about $5.4 billion. It placed fourth on the list of top-selling ETFs.

Commenting on the big inflows in 2009 despite the decline in prices, Hyland said it appears large numbers of investors were looking for a rebound in natural gas prices, which have risen over the past few weeks.

Matt Hougan, editor of, said it's remarkable that in November, the ETF's year-to-date inflows were larger than its assets as investors kept pumping money into the fund all the way down. The fund in 2009 was "an inferno for destroying investors' money," he said.

There were also problems with the arbitrage mechanism because UNG stopped creating shares for a period last last year, due to some investigations over commodity manipulation by the CFTC.

Anyone following this blog wouldn't be surprised—I had several posts similar to what I'm writing now—but for those not familiar, this is a very good lesson in commodity investing.

When I say commodity investing, I'm referring to investing in actual commodities. This is completely different from investing in businesses that deal with commodities. If you are investing in natural gas, the nature of the futures curve matters a great deal, whereas natural gas stock investors aren't as vulnerable. To see how horrible this ETF was, check this out:

The top chart shows the price of natural gas while the bottom is the ETF. Although the ETF doesn't track the index that is shown above, it is supposed to be very close. Yet, we had massive losses for the UNG fundholders. The price of natural gas was largely flat last year, while UNG declined 56.5%! One of the most painful things in investing is when you get the macro call right but the security you invested in turns out to be a total dud. If you thought natural gas would hold its ground, you ended up being right; but if you invested in UNG, you had little chance of coming anywhere near break-even.

Jim Rogers always says that commodities are safer than stocks but if you aren't very good, you will lose large amounts of money very quickly and without knowing why (in contrast, stock market investors are generally bailed out by the economy because it tends to grow over the long run.) In this case, anyone misjudging the contango was roasted alive with slim chance of breaking even any time soon. However note that those betting on the contago in oil late 2008, when it looked bad for oil, when people were storing it on anything they can get their hands on, made a killing earlier last year.


12 Response to Worst non-leveraged ETF of the year: UNG

January 7, 2010 at 3:06 PM

On my quest to figure out how to play natural gas....I looked at UNG. I think with the contango..etc. the ETF really got killed to an extreme. I am currently long UNG and it seems to be tracking fairly decently. I am thinking of switching to a strategy of going long the natural gas trusts, specifically some of the small cap ones that have been destroyed(WTU...SJT). I am optimistic on WTU if it survives, it will rebound fairly well, but if not it will liquidate higher than the current price assuming natural gas holds its bottom. I still have my deflationary trades on..but am getting a bit cautious. If the dollar rally continues, I am  convinced it will ultimately lead to another stimulus towards job creation which is already being talked about in certain circles in Washington. Hopefully this dollar rally will lead to a great buying oppurtunity in some emerging markets/agricultural stocks which have almost doubled since the bottom.

Sivaram Velauthapillai
January 7, 2010 at 4:51 PM

There are also other ETFs like UNL which may behave slightly differently.

Sunny: " I am currently long UNG and it seems to be tracking fairly decently."

I think you'll be fine as long as the contango isn't too big. Also, don't forget that you will gain a bonus if natgas goes into backwardation.

What will hurt you is if you keep losing 3% every month on the roll due to contango. After 10 months, you'll be down 30% without the price moving much.

Sunny: "...assuming natural gas holds its bottom."

What do you think is the bottom for natgas prices is?

January 7, 2010 at 7:49 PM

I think the bottom that was created in August/Septemeber will hold and if natural gas goes down from here, it will still be a good buy long term. I think the whole shale thing is way too overhyped. Also, China is creating natural gas pipelines though central asia which tells me that they are viewing it as an important natural resource.

Ive noticed a trend usually when something goes down a lot..financials, nat gas..etc. Usually there will be some fundemental problem, for example, natural gas had a huge oversupply as stated by analysts. Then in august, september a lot of 'smart' market commentators said ther was a "100 years supply of natural gas" due to shale gas. First of all, drilling for shale gas only makes sense with natural gas priced at $8-$10. Secondly around that time many companies had basically shut down their production of natural gas. So this in essence created a bottom. Also, drilling for shale gas has significant environmental impats(there are many things to consider..including the demand side..pickens plan, nat gas cars .etc)  The problem I have usually is that I get in way early(ex. some financials were cheap in 2008 and subsequently got way cheaper). This time with natural gas I didint get in as early as other Im sort of learning in my relatively new investment career that when wallstreet says that Natural Gas is a "value" in july...DONT BUY....wait for the market to signal a bottom. Unfortunately, while many may can you rely on technical analayis? I'd respond by saying that with anything that falls 50% can fall 70% or 80% or 90% and its better to let a big investor step in and make the bottom. Just some thoughts...

Sivaram Velauthapillai
January 8, 2010 at 12:39 AM

Natural gas is attractive from a contrarian point of view; but the fundamentals are a bit dicey. These are the type of situations where you can make a killing but also end up losing a fortune. It'll be a good lesson one way or another.

As for technical analysis, use what works for you. Different techniques work for different people and I'm not the type that believes that everyone needs to follow one path. How long have you been investing? Did you start in the last year or two, or were you doing it before the crash?

January 8, 2010 at 6:27 PM

Yes...unfortunately the fundamental picture isnt quite clear at the bottom. But reading through a few EIA reports, there really appears to be an energy problem in the long term, assuming that emerging market growth continues and more chinese and indians choose to live the way we do in US..etc. It is actually astonishing how little oil/gas the emerging markets currently use and that if cars became a lot cheaper to make due to technicological processs(TATA nano..etc.), that there will be a lot more drivers. The problem at least to me is that throughout a bull market in commodities, there can be extremely severe corrections (oil going from 150 down to the 30's). Also there are always issues of how long it takes to drill and retrieve those commodities as well. And from what I've seen, a lot of commidity companies are cylical(therfore taking out loans to find these assets), meaning that if credit is tight, it will be difficult to get a loan to continue to find these assets. On the other hand I believe that there has been extreme overbuilding in the world, espically China and India(where both might have a property bubble). So on the one hand certain commodities such as copper have gone up incredibly, something like natural gas has lagged relatively. Interestingly enough, agriculture has been an underperofmer where in 2008 the economist was raving about the food shortages and problems that are ahead of us but now no one is really talking about it.

I actually started investing at the most inopportune time around October 2007 after starting my first job out of college. I followed both Rogers and Faber since summer of 2007 and was very skeptical of their forcasts initally. But this time they were right, and now Im trying to go back and find a lot fo Faber's older work. At first I made a lot of rookie mistakes, like believing Barrons did sufficent analysis of stocks (AIG: A huge oppurtunity Feb 2008). After a few disastrous investments in AIG, MER, GS I decided to buy a financial index etf as a contrarian play. It was very gutwrenching to be adding to these investments as I saw others selling in January and Feburary 2009. A lot of these investments recovered, but it was only through this crisis I realized that there was a lot more to investing than just "financial analysis" - that controlling one's emotions and acting rational in an irrational market was just as important, if not more. Also, I am in the crowd that thinks that there is a lot more to being an investor than just bottoms up cash flow analysis....that its more important to know the underlying secular trends that are creating the ROE and operating margins that investors are engrained to see.

Sivaram Velauthapillai
January 9, 2010 at 11:08 PM

Well, at least you got some early lessons with those financials. Perhaps it was very costly and painful but I'm sure the lessons you learned would last a lifetime.

I was heavily influenced by Marc Faber and my investing style is sort of like his--but I'm trying to be more of a value investor. I encountered him when I started investing in 2004 but he wasn't popular back then. Certainly the commdity complex wasn't exactly in the mainstream view.

My view deviated from Faber's (and Rogers') when I became bearish on commodities in 2006 or thereabouts. So I haven't followed any of his investing advice for a while. However, I do pay attention to Faber because he understands the macro situation far better than most. He is also one of the few contrarians so as a self-professed contrarian-wannabe ;)  I have to follow him. (These days I like Hugh Hendry a lot more and think about his views more.)

Sivaram Velauthapillai
January 9, 2010 at 11:23 PM

Don't let me influence you too much with what I am about to say. I have bene bearish on commodities for 3 or so years and been wrong (I think.)

I'm not bullish on commodities, like you are. First of all, I like to treat natgas separately from all the others because it is very localized. Sure, there is LNG and stuff but for the most part, it is set by the local market. In any case...

Although the future outlook from developing countries implies that commodity demand should remain strong for decades, I am not so sure for two reasons.

Firstly, it's not clear to me that the price of commodities hasn't already factored in a lot of the bullish upside. Everyone has their own view of what the marginal cost of production of oil is, but if we say it is something like US$30 to $40, then the current price that is well above $30 implies that the market may be discounting the upside. Copper's marginal cost of production may be as low as $1.50 (I'm not really sure) while the current price is over $3.

Secondly, although the future of emerging markets looks strong, I am very cautious. Knowning history, what looks like a given turns out not to be so. For instance, many in the early 1900's thought China was going to be a major emerging market yet it turned out to be completely wrong. People thought Argentina had a bright future but it has been declining for almost 100 years.

One of the problems I see with the rosy commodity projections is that it doesn't make long term sense to me. For instance, if people in China or India consumed (per capita) even half of the oil consumed by the developed world, there would be so much pollution, enivirnomental problems, and so on, that we could see millions of people dying from the pollution. People who are superbullish on oil don't seem to explain what would happen to China if there were an extra 200 million cars on the road.

Then we have the whole potential of bubbles, although one can never be certain what is a bubble except in hindsight--strong growth may look like a bubble when in fact it isn't (eg. consumption boom in USA in 1950's and 1960's.) CAn a country like China just keep building for decades? I don't know. If it slows down, there is no one else that will consume steel/nickle/copper/etc at the same rate.

January 11, 2010 at 3:03 PM

Yes, your right the marginal cost of production is very cheap for oil in Saudi Arabia, but not for oil in the Gulf of Mexico or Canda..etc. Basically cheap oil is the middle east is declining, and Im sure youve heard most of the arguements before, but there is no 'easy answer' for the worlds energy problems. I am actually quite bullish on carbon credits as well(GRN), becuase I think something will be done about the enviornment, and currently the consensus is that nothing will be done since the Copenhagen summit was a failure. I'm not confident enough yet on this position to buy though.

January 11, 2010 at 3:03 PM

I definetly agree with Chanos, Shedock and you that there is a credit bubble in China. China will definetly have problems in the coming years basically switching from a straight export-based economy...with these State Owned Enterprises and the goverment allocation of resources and investment to a more free economy with entrepeneurs and such driving economic activity. So basically I agree with you that things will be very bad for China in the next few years as this painful adjustment happens, with probably industrial commodities and oil falling. But does that mean all commodities should be valued the same? I think copper, steel and some industrial commdoties are overvalued currently while agricultural commodities and natural gas(back in novermber/december) were undervalued. I still think the middle class chinese will consume more coffee, rice, oil at a much smaller level than the US but will grow much faster. Obviously the bears will point to Japan and say they never recovered...but it will be interesting to see what happens.

With your point of view, I think it is essential to know both sides of an arguement and have a good number of bears for an asset to be worth investing in (for me). That is why im not bullish on the BRIC's and emerging economies at this present time. I think after the whole emerging bubble bursts again, there will be some great investment oppurtunities in the space. I think it is important for an investor to do his or her own reearch and not be influenced by anyone, including Buffet or Faber when making investment decisions, since the timeframe for professionals vary greatly in comparison  to me. Also, im am wary of all projections, including the earnings projections of AMZN with a p/e of ~80 in this economy. But considering this, we must realize that Bernanke has literally provided a stimulus of ~21 trillion including all fed gaurantees, asset purchase plans, increased monetary abe..etc. This is what makes valuations very very difficult in this economy. But as Hendry states correctly, the big banks of the world have ~100 trillion of derivative exposure as well as credit growth slowing down since June 09. But if there is no mark to market, then I suppose these problems dont exist?!?! Either way, for the individual and professional investors, returns will be incredibly hard to make, or better yet, keep.

January 11, 2010 at 3:03 PM

But this is why I look at extremely distressed situations to come in and invest(the sector down 75% or more). A lot of the negatives of natural gas has been priced in I believe. But I will wait for a significant dollar rally to add to myposition and I will probably reposition my natural gas investments to natural gas trusts, preferably with low p/e's. For example, WTU with a p/e of 4 and just sitting on it since it runs on no debt and just waiting for it to either liquidate at a higher price or increase. My last point is about emerging markets is that although the credit crisis intensified in 2008, both India and China consumed a lot of energy during this period. This lead me to believe that even with the high unemployments and low realtive gdp's that there is a an underlying secular trend in energy. Also the energy use of Japn is approximatley 250 quadrillion btu's with a population of ~127 million while the enregy use of India is currently 180 quadrillion btu's with a population over 1 billion. I dont think India will get to 250 overnight, but over the next 10 years, I think it could. For me the fundamentals are strong, its just a matter of price.

Sivaram Velauthapillai
January 11, 2010 at 5:48 PM

I kind of share your feeling that soft commodities (agriculture) is probably a bit safer than industrial metals. I'm still not sold on them due to them being political commodities (i.e. food prices are a big political issue in poor countries).

It'll be interesting to see what happens with energy. Some argue that the high oil prices were part of the cause of the crash in 2008. If so, US$147 per barrel of oil seems unsustinable. But then again, others believe oil is getting scarcer and believe we may have hit Peak Oil.

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