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Natural Gas ETF: Definition – How to Invest – Best Examples

What is a Natural Gas ETF?

Natural Gas ETF

Natural gas is a commodity used as a source of energy for heating, cooking, fuel, and electricity generation. It also is used in the manufacture of plastics and other organic chemicals. The price of natural gas rises and falls according to fluctuations in supply and demand.  A natural gas ETF is an exchange-traded fund that helps investors obtain exposure to returns based on the performance of natural gas.  Natural gas ETFs fall under the broader category of commodity ETFs. A natural gas ETF tracks the equity of natural gas producers or the price of natural gas itself.

In theory, commodity ETFs should be easy to create. However, that’s not quite true. No asset management company wants to stockpile truckloads of natural gas in their backyard. As a result, exposure to natural gas must be achieved through alternative strategies. Natural gas exchange-traded funds (ETFs) provide investors with exposure to natural gas prices.  They do this while avoiding the complexities of trading natural gas futures contracts.  They also avoid the burden and storage costs to hold the physical commodity.

Different Approaches for Natural Gas ETF Funds

When an asset management company wants to create exposure to natural gas, the cleanest, cheapest, and most efficient method is to take a long position in the futures contract of natural gas. For an average investor, the process may seem daunting.  However, an ordinary retail investor does not have any other viable means of gaining exposure to a volatile asset class, such as natural gas, without having a futures account. Even if an investor purchases a futures contract, there is the unpleasant requirement of daily mark to market margins and the possibility of the dreaded margin call. By using a natural gas ETF, a retail investor can get exposure to a complex derivative under the structure of a plain vanilla financial security. Thereby, it provides access to a varied asset class and provides a means to diversify one’s returns.

Physical commodity ETF – Exposure is obtained by physical possession of the commodity.  However, it is not feasible for commodities like natural gas due to storage costs, insurance, and other non-financial expenses.

Equity exposure-based ETF –  Funds can purchase shares of natural gas companies. This provides indirect exposure based on the performance of the stocks. This is not the ideal method as there are very few pure-play natural gas players.

Futures-backed ETF – Fund managers can purchase a natural gas futures contract and roll it over as time passes. This method provides the highest correlation to the prices of natural gas among the three options. As a result, it is the preferred method for commodity exposure.  (Source: corporatefinanceinstitute.com)

Returns from a Natural Gas ETF

Natural gas ETFs allow an investor to generate returns based on the prices of natural gas via three channels. They are as follows:

Spot returns

It is the conventional means of returns, wherein the law of supply and demand governs the returns. If natural gas is in short supply due to some production bottlenecks, the prices will inevitably shoot up. On the other hand, a paucity in demand owing to milder winters will drive down prices. Natural gas is one of the few commodities with a predictable stream of supply but an unpredictable demand curve. On the other hand, food-based commodities demonstrate stable demand but uncertain supply visibility.

Roll yield

Derivatives cannot be treated like normal cash-based securities. Hence, a conventional buy and hold strategy cannot be used. Typically, futures are bought for a short duration with the intention of renewing the contract or, in financial terms, rolling the contract over. During the course of the rollover, two things are possible: either the futures price is greater than the spot or vice versa. The yield that can be earned above is referred to as rolling yield. It is the primary source of return for investors. Though it looks quite complicated, in reality, it is a combination of taking risks along with elements of arbitrage. Lastly, no asset manager wants to take delivery of physical commodities owing to several constraints, such as storage, transportation, and finally, the lack of end-use. Therefore, the contracts must be rolled over and almost never end up in the delivery of the asset.

Cash yield

Any cash that is not invested in purchasing futures would be deployed to purchase some risk-free assets, such as Treasury bills or government securities. The returns generated from the assets constitute cash yield. It is not the primary source of returns but is a mechanism put in place to deal with operational issues and tactical allocation of capital based on the fund’s mandate.  (Source: ibid)

The Natural Gas Market

In late June 2020, Credit Suisse made a surprise announcement.  It was abruptly discontinuing several of its popular 3x leveraged ETNs.  This included the natural gas products UGAZ and DGAZ. As 3 times leveraged ETNs of one of the most volatile commodities, these funds were very popular with day traders and swing traders.  This is because daily moves could exceed +/-30%. However, for longer-term holders, they were chronic underperformers.  This was due to leverage-induced decay and rollover losses. Additionally, their extreme volatility made them liabilities.  This was following the well-chronicled debacle with the leveraged oil ETFs UWT & DWT around the time WTI went negative. Once these products were effectively discontinued interest in trading natural gas ETFs waned as investors lost key trading vehicles.  You can still trade UGAZF on the OTC but it no longer reliably tracks natural gas.  (Source: seekingalpha.com)

Natural Gas Prices

Natural gas prices have risen at a faster pace than the S&P 500 over the past year. The three natural gas ETFs, ranked by 1-year trailing total return, are UNL, GAZ, and UNG. All three of these ETFs hold natural gas futures contracts to gain exposure to natural gas prices. ETFs with very low assets under management (AUM), less than $50 million, usually have lower liquidity than larger ETFs. This can result in higher trading costs which can negate some of your investment gains or increase your losses.

There are three natural gas ETFs that trade in the U.S., excluding inverse and leveraged ETFs. These are funds that hold natural gas as a commodity or commodity futures, not the stocks of natural gas companies. Natural gas prices have risen 64.8% over the past 12 months compared to the S&P 500’s total return of 18.9%, as of February 10, 2021.  The best natural gas ETF, based on performance over the past year, is the United States 12 Month Natural Gas Fund (UNL). All numbers below are as of February 11, 2021. (Source: investopedia.com)

Best Examples

The United States 12 Month Natural Gas Fund (UNL)

  • Performance over 1-Year: 13.4%
  • Expense Ratio: 0.90%
  • Annual Dividend Yield: N/A
  • 3-Month Average Daily Volume: 24,617
  • Assets Under Management: $7.9 million
  • Inception Date: November 18, 2009
  • Issuer: USCF

iPath Series B Bloomberg Natural Gas Subindex Total Return ETN (GAZ)

  • Performance over 1-Year: -19.3%
  • Expense Ratio: 0.45%
  • Annual Dividend Yield: N/A
  • 3-Month Average Daily Volume: 6,202
  • Assets Under Management: $3.9 million
  • Inception Date: March 8, 2017
  • Issuer: Barclays Capital

GAZ is structured as an exchange-traded note (ETN), a type of unsecured debt security that does not make interest payments and has stock-like characteristics. The fund provides exposure to natural gas prices through the holding of natural gas futures contracts. As an ETN, GAZ exposes investors to the credit risk of the issuer. Also, this ETN doesn’t generally move with changes in spot natural gas prices because the underlying index is comprised of futures contracts. It is designed for investors with a short-term investment horizon, rather than as part of a buy-and-hold strategy.

The United States Natural Gas Fund (UNG)

  • Performance over 1-Year: -22.7%
  • Expense Ratio: 1.33%
  • Annual Dividend Yield: N/A
  • 3-Month Average Daily Volume: 5,634,894
  • Assets Under Management: $354.4 million
  • Inception Date: April 18, 2007
  • Issuer: USCF

Like UNL, UNG is also structured as a commodity pool, offering exposure to natural gas prices by holding natural gas futures contracts. Unlike UNL, however, this ETF is not as diversified, investing in futures contracts set to expire within the next month.6 This means the fund is more exposed to the adverse impacts of contango and is thus more appropriate for traders with a short-term strategy. It may also be appealing as an inflation hedge.

(Source: ibid)

Current List of Natural Gas ETF and ETNs

These are the current natural gas ETF that are available to trade on today’s exchanges. And while these funds may seem attractive, they are not without risk.

  • BOIL – ProShares Ultra Bloomberg Natural Gas ETF
  • KOLD – UltraShort Bloomberg Natural Gas ETF
  • DDG – ProShares Short Oil and Gas ETF
  • DRIP – Direxion Daily S&P Oil & Gas Exp. & Prod. Bear 2X Shares ETF
  • GUSH – Direxion Daily S&P Oil & Gas Exp. & Prod. Bull 2X Shares ETF
  • FCG – First Trust Natural Gas ETF
  • FRAK – VanEck Vectors Unconventional Oil & Gas ETF
  • FTXN – First Trust Nasdaq Oil & Gas ETF
  • GAZ – iPath Series B Bloomberg Natural Gas Subindex Total ReturnSM ETN
  • UNG – United States Natural Gas Fund ETF

As you go through this list, be sure to investigate each fund closely. Watch how they interact with market conditions.  Also, look at their quote history and even take a look under the hood and see what is in the fund. Many leveraged and inverse funds contain derivatives such as options and futures to achieve their goals.  As a result, it’s important to understand how they work. Know your risk and be sure to ask for professional guidance if needed. (Source: thebalance.com)

Warren Buffett’s Berkshire Pays $10B for Natural Gas Assets

Value investing icon Warren Buffett has been fairly quiet during the coronavirus pandemic, but the Berkshire Hathaway CEO pulled the trigger on a $10 billion deal to purchase the natural gas transmission and storage assets of Dominion Energy. As such, investors may want to keep an eye on natural gas ETFs if the “Oracle of Omaha” is seeing an opportunity in the commodity. This is the first major purchase of Berkshire Hathaway before the pandemic struck in March. Before the purchase, the holdings company didn’t make any waves in the capital markets—Buffett stated that inaction was the best move at the time. “We have not done anything because we don’t see anything that attractive to do,” Buffett said . (Source: etftrends.com)

Up Next: Day Trading For Beginners – What Is A Day Trader

Day trading can be summarized simply as buying security.  Then, quickly selling or closing out the position within a single trading day.  Ideally, a day trader wants to “cash-out” by the end of each day with no open positions to avoid the risk of losses by holding security overnight.  Day trading is not for everyone and carries significant risks. It requires an in-depth understanding of how the markets work and various strategies for profiting in the short term.  Short-term profits require a very different approach compared to traditional long-term, buy and hold investment strategies.

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