The problem with commodity ETFs  

The FT's Alphaville blog has an interesting (albeit dense) post on the goings on in the natural gas futures market, driven by the weight of money people have ploughed into exchange traded funds based on the natural gas price (who seem to be getting fleeced just as efficiently as punters investing in the equivalent ETF for oil have been) - The problem with commodity ETFs.

The day ahead of the United States Natural Gas (UNG) ETF’s futures roll from the July to August contract, Olivier Jakob of Petromatrix — who has inadvertently become a bit of a lone crusader in the mission to expose the influence of exchange traded funds on commodity markets — presents an impressive summary of the story so far.

His primary observation:

ETFs [based]on Commodity Futures have a basic design flaw in that they are open-ended fund that invest in assets (Futures) that are close-ended (either due to CFTC regulation or due to lack of liquidity). This is a major contradiction that is at the source of market dysfunctions.

At issue currently is the rampant growth of the UNG, the natural gas positions of which have doubled since last month’s roll. This growth, by the way, is eerily similar to that experienced by the ETF’s sister fund, the USO, earlier this year - the background to which you can read about here.

In the UNG’s case, however, the growth has been so large that in order to avoid a regulatory clampdown on its futures positions the fund managers have been forced into the world of over-the-counter swaps. Accordingly, the fund’s swap positions are now 2.6 times larger than its future ones.

To give some perspective, if the fund was to put all that money into the futures market, Jakob calculates it would be equal to occupying 78 per cent of open interest in the July Nymex contract. Meanwhile, the holding of large swap positions goes against the fund’s mandate as outlined in its prospectus.

As Jakob explains (our emphasis):

The UNG prospectus states that the UNG will “invest primarily in Futures Contracts”. The total net assets of the UNG have now reached 3.5 byn usd which if it was invested in the front Futures month (as implied by the prospectus) would amount to 92′879 Nymex Natural Gas Futures contract; this compares to an Open Interest on the prompt Futures contract (July) of 119′100 contracts. This would amount to 78% of the July Futures Open Interest. To have one entity directly holding such a share of the Futures Open Interest would probably not be tolerated by the CFTC. So, to keep the regulators at bay, the fund appears to have delved deep into the swap market after reaching a futures position equal to about 21 per cent of the open interest in July Nymex Natural Gas futures.

From the perspective of ETF investors, this might be a concern because swaps are not simple instruments. They are the domain of physical market specialists and are open to much more complex pricing procedures based on cumulative averages. It’s not as simple as tracking a front-month future price.

What’s more, looking at the subsequent swap build-up, another trend emerges. The UNG seems to have stopped investing in July Nymex Henry Hub swaps after reaching a position equal to 33 per cent of open interest. Since May 20th all new investments have been flowing specifically into ICE swaps instead. As ICE does not publish swap open interest, however, it is impossible to ascertain the fund’s relative position here.

The strangest thing of all, however, is the context of the fund’s build-up. Just like with the USO, it comes mostly in a declining price-environment and a contango shaped curve. Contango, as explained here, poses a challenge to funds whose methodologies oblige them to keep rolling futures contracts into ascending prices to maintain their positions. Simply stated, every roll registers a loss.

If you consider that it was only when the USO began to shed positions that the price of crude eerily began to rise, there may indeed be something to it. In fact, even now, the more the USO sheds, the more the price of crude seems to rise and the contango flatten more. As Jakob explains:

The USO holdings of WTI Futures peaked at 96′500 contracts on the 19th of February. On the 24th of February, Platts revealed that the CFTC was contacting the USO in view of their holdings in WTI Futures and the CFTC then made a public statement about the same on the 27th of February. Since then the WTI holdings in WTI have continuously been reduced.

The fact the UNG is building positions into a heavy contango curve therefore strikes us as somewhat illogical. What’s more, the more it builds, the firmer the contango appears to be getting, as this chart from Jakob shows ...