Natural-gas ETFs hit on weather, supply

BOSTON (MarketWatch) — Lost in the shuffle of surging oil prices and Middle East unrest is the pullback in exchange-traded funds that invest in a different energy source: natural gas.

Exchange-traded products that track natural-gas futures such as U.S. Natural Gas Fund(UNG 5.42, +0.06, +1.17%) and iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN (GAZ 7.18, +0.22, +3.16%) have shed more than 10% so far this year.

Despite a bounce Friday, natural-gas prices have trended steadily lower since late January on expectations of milder temperatures as winter winds down.

“Natural gas is the commodity that slept through the commodity party,” said Tom Lydon, editor of ETFtrends.com. “Supply is through the roof and clean energy just isn’t catching on as fast as many have hoped.”

Crude-oil prices, meanwhile, surged above $100 a barrel in New York last week on fears political unrest in the Middle East and North Africa could lead to further supply disruptions.

U.S. Oil Fund (USO 39.44, -0.24, -0.61%) broke free of its recent range and traded above $40 a share for the first time since May.

“There is a curious disconnect between the spike in oil prices and the performance of natural gas and other alternative energy plays,” said Michael Gayed, chief investment strategist at Pension Partners LLC.

“There is a tug of war going on internally,” he added. “While investors in oil are clearly betting that supply disruptions are likely to occur, investors in alternative energy aren’t.”

Weak support

Natural-gas prices have weakened even though data from the Energy Information Administration shows supply is lower than a year ago, and near the bottom of its five-year range, said John Hyland, chief investment officer at United States Commodity Funds LLC. The firm manages U.S. Natural Gas Fund and other energy-sector ETFs.

“With below-average inventories, the market seems to believe the weather will warm up and that winter-heating usage will moderate from here, resulting in rebuilding inventories,” Hyland said.

Discoveries of shale gas have also weighed on prices in recent years, he said. See Commodities Corner on natural-gas supply surplus.

Natural-gas prices have traded lower “as warm temperatures over the past week have depressed demand and comfort with inventory levels at the end of the withdrawal season has damped bullish sentiment,” Barclays Capital analysts wrote in a Feb. 22 note.

“Since mid-January, prices have been on a slide, giving up gains made earlier in the winter,” Barclays said. “For one, temperatures have warmed, reducing the risk of a complete market reset. Second, winter is almost over, allowing the market to breathe a sigh of relief.”

When using exchange-traded products based on commodity futures, investors need to remember they don’t follow the “spot” price.

For example, U.S. Natural Gas Fund invests in the near-month futures contract.

“Effectively, the fund sells its soon-to-expire position and purchases a contract further from expiry to avoid physical delivery,” Morningstar Inc. analyst Abraham Bailin noted in his latest research report on the ETF.

“When the prices of those back-month contracts exceed the price of the front-month contract (known as a state of “contango”), the fund loses money each time it rolls its position,” Bailin wrote. “In contangoed markets, a fund like U.S. Natural Gas Fund can suffer heavy losses even as natural gas prices rise, warranting investor caution.”

Also, since the fund is structured as a limited partnership, it has different tax treatment from other types of ETFs, he said.

United States Commodity Funds also oversees U.S. 12 Month Natural Gas Fund(UNL 32.26, +0.79, +2.51%) , which attempts to dampen the effect of contango by investing in longer-dated futures contracts.

First Trust ISE-Revere Natural Gas Index Fund (FCG 22.51, +0.19, +0.87%) is an ETF that invests in natural-gas companies. It has held up much better than the natural-gas futures products recently with a year-to-date gain of more than 10%