What is a Natural Gas ETF?
Natural gas ETF is defined as an exchange-traded fund that helps investors obtain exposure to returns based on the performance of natural gas. Natural gas ETF falls under the broader universe of commodity ETFs.
In theory, commodity ETFs should be easy to create. However, that’s not quite true. No asset management company would be keen on stockpiling truckloads of natural gas in their backyard. Such a constraint necessitates exposure to natural gas via an alternative mechanism.
Different Approaches for Constructing Natural Gas ETF
1. Physical commodity ETF
- Exposure obtained by physical possession of the commodity
- Practically not feasible for commodities like natural gas due to storage costs, insurance, and other non-financial expenses.
2. Equity exposure-based ETF
- Purchase shares of natural gas companies
- Obtain indirect exposure based on the performance of the stocks
- Not the ideal method as there are very few pure-play natural gas players
3. Futures-backed ETF
- Purchase a natural gas futures contract and roll it over as time passes
- Highest correlation to the prices of natural gas among the three options
- The preferred method for commodity exposure
How It Works
- If an asset management company wants to create exposure to natural gas, the cleanest, cheapest, and most efficient method would be to take a long position in the futures contract of natural gas.
- The process may seem cumbersome, but, in reality, an ordinary retail investor does not have any viable means of getting 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.
- Using a natural gas ETF, a retail investor can get exposure to a complex derivative under the structure of a plain vanilla instrument. Thereby, it democratizes access to a varied asset class and provides a means to diversify one’s returns.
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:
1. 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.
2. Roll yield
- Derivatives cannot be treated like a normal cash-based security. 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.
- If the futures price is greater than the spot price, then it is called contango and is a losing proposition for the investor. Consider an investor who purchases a contract to take delivery of X MMBTU of natural gas for $4 at the end of the next three months. Suppose the spot price is $3, and it does not move by much until the end of the three-month period. Based on the arbitrage principle, on the date of the expiry, the futures price will converge with spot. As can be seen from the information above, it will lead to a loss of $1 per contract.
- However, if the futures price is lower than the spot price, which is called backwardation, then the investor earns a positive return. For example, an investor purchases a contract to receive Y MMBTU of natural gas for $2 in one month, and the spot price is $3. On the day of the expiry, if the spot price remains unchanged and the law of arbitrage kicks in, the investor will earn a profit of $1.
- Now the question that would arise is why does the futures trade at a discount to the spot? Doesn’t the time value of money come into play? It indeed does, but the impact of the same is eroded away by something known as convenience yield (benefits from physically holding the asset).
Prices in the Future = Current Cash Price + Costs Associated with Ownership – Benefits Due to Ownership
- 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.
3. 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.
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