Be Careful When Catching Natural Gas Falling Knives

Buoyed by rebounding energy prices, the United States Natural Gas Fund UNG gained 2.6 percent last week while the equity-based First Trust ISE-Revere Natural Gas Index Fund FCG surged a jaw-dropping 17.6 percent and that is even with FCG sliding 1.8 percent on Friday.

Impressive gains to be sure, but last week's showings do little to dent year-to-date losses of 21.6 percent and 34.2 percent, respectively, for UNG and FCG. Those gains may be short-lived as the weather phenomenon known as El Nino is expected to lead to a mild a winter for the U.S. East Coast and Midwest, likely tempering demand for natural gas.

That has not prevented traders from pumping cash into UNG since the start of October. UNG, the largest futures-based natural gas ETF, is now home to $650 million in assets under management thanks to the arrival of $100 million in fresh assets since Oct. 1. That does not mean UNG is a free lunch. Far from it.

“An understanding of the intricacies of trading futures contracts is required in order to avoid adverse investor experiences. Investors should note that UNG rolls near-month natural gas futures contracts trading on the Nymex in an attempt to track the price of natural gas. However, performance will not track natural gas spot prices because of roll-yield costs related to the shape of the futures curve,” according to a recent Morningstar research note.

As the research firm points out, due to UNG's rolling of near-month natural gas futures contracts and the associated expenses, there have been years in which UNG has traded lower while natural gas has appreciated in price.

“It is because of this basis risk that we view the ETF as a short-term play and not a long-term investment. Still, for all of its shortcomings, UNG is the best way for investors to get exposure to movements in the price of natural gas. More-recent performance has been relatively in line with spot prices,” adds Morningstar.

As for FCG, the equity-based natural gas play has it own set of problems. Primarily, the ETF has a tendency to lag UNG when natural gas prices rise, last week not withstanding. For example, over the past three years, UNG has tumbled nearly 47 percent, but FCG has plunged 57.1 percent.

Several years ago, amid a glut of natural gas supply, sliding prices and what looked to be sturdy oil prices, some of FCG's holdings moved to increase oil output. That clearly has not worked in the ETF's favor as oil prices, though recently improved, are currently mired in a lengthy bear market. Still, the Energy Select Sector SPDR XLE, the larges equity-based energy ETF, is flat over the past three years.

In the near-term, FCG has another issue to contend: Slack energy sector earnings growth. By some estimates, the sector's third-quarter earnings are expected to falter by 60 percent or more. Perhaps that is already baked into FCG, an ETF down almost 13 percent over the past 90 days and one that labors at barely more than $7 per share.