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When Trading Natural Gas, Don't Forget This Fund

By The Financial Lexicon | Tue, 27 November 2012 23:07 | 0

If you are an investor who wants exposure to commodity futures but does not want to trade the futures yourself, there are now plenty of exchange-traded products available to help you achieve your goals.  When it comes to natural gas, a well-known fund is the United States Natural Gas Fund, ticker symbol UNG.  But there is also a lesser-known natural gas fund available that investors should be aware of: the United States 12 Month Natural Gas Fund, ticker symbol UNL.  Natural gas traders using exchange-traded products should keep in mind that there are times to trade UNG and other times to trade UNL.  And knowing when to trade one or the other can help you add to your returns over time.

The United States Natural Gas Fund tracks Henry Hub natural gas prices through futures contracts traded on the NYMEX.  More specifically, UNG purchases the futures contract that is “the near month contract to expire, except when the near month contract is within two weeks of expiration.”  When the contract is within two weeks of expiration, UNG will purchase the next closest month’s contract.

On the other hand, the United States 12 Month Natural Gas Fund, which also tracks Henry Hub natural gas prices through futures contracts traded on the NYMEX, purchases the nearest 12 months of contracts and trades off of the average price of those contracts (each contract is equally weighted).  UNL also closes out the front month contract when it is within two weeks of expiration, rolling the funds into a new contract.

As a result of the steep contango that natural gas futures have traded in for quite some time, UNG, the fund that tracks the front month contract, has suffered severely.  The effect of constantly selling contracts at lower prices than it buys the next month’s contract, only to see the prices eventually converge, has taken a big toll on UNG’s share price over time.  While UNL also suffered losses during recent periods of falling natural gas prices, it would have sheltered investors from the types of losses UNG experienced.  This is because UNL owns 12 contracts, some of which are on a part of the futures curve that didn’t suffer from the same type of brutal declines the front month contract suffered.

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For example, during the declines in natural gas prices from June 9, 2011 through April 19, 2012, UNG fell 71.82%.  During the same time, UNL fell “only” 58.61%.  The reason for UNL’s outperformance is that the steepness of the contango, as is often the case, was greater at the front end of the futures curve.  Since the April 19, 2012 lows, however, UNG is outperforming UNL.  From the April 19 low through the November 23 close, UNG rose 61.33%.  UNL was up just 33.24% during the same time period.  Why was there a reversal between the two funds in terms of which one outperformed?  It was because as the contango narrowed, the largest part of the narrowing occurred, as one might expect, in the nearest month contracts.  This benefitted UNG. 

What can investors glean from this information?

1.       When natural gas futures are in contango, and the price is in a downtrend, long-biased investors should own UNL, and short-biased investors should short UNG.

2.       When natural gas futures are in contango, and the price is rising, long-biased investors should own UNG, and short-biased investors should short UNL.

Even though UNG’s average 90-day volume outpaces UNL’s by roughly 200 to 1, it doesn’t mean you should automatically ignore UNL as a way of trading natural gas.  The less interest in UNL, the better opportunity you have, as a natural gas trader, to use the fund as a means of outperforming your peers.

By. The Financial Lexicon

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