The weak macro economic situation across the globe has had
significant impact on investors worldwide. Over the past six
months, we have witnessed a sharp increase in volatility across all
asset classes.
However, the near future doesn't look very optimistic either.
Especially if the slippery situation across both sides of the
Atlantic worsens or even remains the same (read
Three Defensive ETFs for a Bear Market
).
Commodities so far have had a dismal year as well. Many of the
finished goods export oriented economies such as China, Hong Kong,
and South Korea have witnessed a considerable decrease in their
industrial production (read
Top Commodity ETFs in This Uncertain Market
). This is mainly due to reduced import demand from their trade
partners, especially the debt plagued Euro zone nations, and to a
lesser extent, America too.
This trend, along with a strong dollar, has pushed commodity
prices lower with many key global resources remaining under
pressure for the year.
Closer to home, investors have seen a similar situation in the
natural gas market as well, as the commodity remains well below its
highs. New technological processes, such as better drilling
techniques, are being implemented and have caused the supply of the
potent fuel to surge.
This sharp increase in supply has coupled with weakness in the
demand picture in recent months to lead to a truly bearish
situation for the natural gas market (see
Beat the Heat with These Three ETFs
).
All these instances taken together have accounted for an
oversupply
situation in the market and have resulted in falling natural gas
prices since the highs of 2008. However, with summer setting in,
the demand for the commodity is finally witnessing an uptrend as
natural gas is also used for cooling requirements in
air-conditioners.
Also, industrial consumption is witnessing a surge as power
plants use natural gas instead of crude oil, to generate
electricity. This trend is also expected to remain for quite some
time, given the fact that crude oil prices are substantially higher
than natural gas prices (on a comparative output basis), and since
natural gas is more environmentally-friendly than coal (see
Two Energy ETFs Holding Their Ground
).
Given this shifting market outlook some investors may want to
consider making a play on this beaten down market segment.
Currently, there are quite a few choices for investors seeking the
ETF route to gain exposure in this commodity segment. However, it
is very important to note the difference between these options in
order to prevent getting singed by natural gas investments.
Broadly speaking, investors can gain exposure by the
Futures ETFs
or the
Equity ETFs
that target this space. These two broad genres of ETFs differ
substantially in terms of their structure, expenses, risks involved
and benchmark indexes (see more in the
Zacks ETF Center
).
Equity natural gas ETFs
basically include stocks of companies that are engaged in the
production and exploration of oil and natural gas in their
portfolio. Therefore, it is implied that these would not be
impacted by the technicalities and complications of the derivatives
market.
However, these ETFs will be exposed to the cyclicality in the
commodity market. Some of these funds include
First Trust ISE Revere Natural Gas ETF (
FCG
)
and
Market Vectors Unconventional Oil & Gas ETF (
FRAK
)
The
First Trust ISE Revere Natural Gas ETF (
FCG
)
is a natural gas equity ETF. It employs a rather innovative
methodology to select stocks from the entire universe of companies
engaged in the energy exploration business. The stocks are screened
and ranked based on certain fundamental factors such as price to
earnings, price to book value, market capitalization and return on
equity.
The ranks are then averaged and the top 30 stocks become part of
the index and are weighted equally. However, it is prudent to note
that these stocks do have the strongest correlation with the
natural gas futures price, therefore it may not be a pure play on
the commodity.
Thanks to this unique methodology, the ETF charges a hefty
premium of 60 basis points in fees and expenses. FCG was launched
in May of 2007 and since then has been able to amass $438.69
million in assets under management. The ETF has an average daily
volume of 554,668 shares and pays out a paltry yield of 0.50%.
Also, the
Market Vectors Unconventional Oil & Gas ETF (
FRAK
)
is another option from the natural gas equity ETF space that
investors might consider investing in. Launched in February of this
year, it is a relatively new ETF in this space.
The ETF is pretty similar to FCG in terms of strategy, however,
it does not offer a pure play in the natural gas segment as it is
exposed to companies involved in exploration instead (read
Three ETFs for The Unconventional Oil
Revolution
).
On the other hand,
Natural Gas futures ETFs
are basically instruments that try to capture the daily difference
in spot prices of natural gas by gaining exposure to future
contracts. Although futures can be considered an efficient, cost
effective way to gain exposure in the commodities market without
having to deal with storage costs and physical delivery, they still
have their own risks.
The
United States Natural Gas ETF (
UNG
)
and the
United States 12 Month Natural Gas ETF (
UNL
)
are some choices available in the Natural Gas Futures ETF space.
The ETFs are almost same in terms of strategy and workings. UNG
takes positions in the near-to-expiry natural gas futures
contracts. As the contract nears maturity, the contracts are rolled
over to the next month (read
Buy American with these Three Commodity ETFs
).
On the other hand UNL does the same thing, but it spreads out
its exposure across contracts with 12 different expiries in 12
months. Both of these products charge a steep expense ratio.
UNG charges 60 basis points, whereas UNL charges 75 basis
points
. However, UNG comfortably beats UNL in terms of total assets and
daily volumes traded.
UNG has total assets worth $1.18 billion and an average daily
volume of almost 10 million shares compared to UNL, whose total
assets stand at $48.46 million and an average daily volume of
55,514 shares. However, both these products have seen the worst of
times in the recent past thanks to the heavy
'contango'
in the natural gas futures market.
Impact of Contango on UNG and UNL.
The strategy of UNG and UNL implies that during roll over (done
in order to avoid physical delivery), the price of the
far-from-expiry contract (which it buys in order to roll-over),
should be lower than the price of the near-to-expiry contract,
thereby booking the differential as profit.
However, if the price of the far dated contracts becomes higher
that price of the near dated contract, the ETFs will book losses
every time the position is rolled over. This happens in a market
which is in "contango". Contango is basically when the futures
price is higher than the expected futures spot price.
A market in contango signifies that supply exceeds demand,
therefore given the oversupply in natural gas and a decrease in
natural gas prices, the natural gas futures market have gone into a
state of contango. This is exactly the reason why these two futures
ETFs have put up a dismal performance in the recent
past.
Is the trend changing?
Given the recent surge in the natural gas prices, one might
think that a reversal has finally set in the natural gas market.
UNG and UNL which have
lost 27.2% and 19.3%
respectively, on a year-to-date basis are starting to post
positive
returns for shorter time frames.
The three month absolute returns for UNG and UNL as on 30th June
2012 were
21.17% and 7.13%
respectively. It was mainly thanks to the recovering demand due to
the anticipated warm temperatures as well as more power plant usage
of the fuel.
Still, for the same time period, FCG fetched
negative returns of 6.86%
. On a
year to date
basis the equity ETF has slumped
8.0%
so the futures could be recovering faster than their equity
counterparts (see
Have the Natural Gas ETFs Finally Bottomed Out?
).
While the traditional buy and hold strategy seems to fail as a
strategy for futures ETFs, for the informed investors, these can be
great money making avenues, especially given the recent trends.
However, it should only be considered by investors with sound
knowledge about the recent trends in the underlying commodity
market.
On the other hand, for the average investors who wish to keep
away from the subtleties in the derivative markets, equity ETFs
provide a buy and hold option, especially for the long term.
This could be especially true in the natural gas market, as the
products targeting this space may finally be on the upswing.
Furthermore, it appears as though they take quite some time to turn
around, implying that gains could still be had in the natural gas
equity market should present positive trends continue.
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FT-ISE R NAT GA (FCG): ETF Research Reports
MKT VEC-UNC O&G (FRAK): ETF Research
Reports
US-NATRL GAS FD (UNG): ETF Research Reports
US-12M NATL GAS (UNL): ETF Research Reports
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