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A Rough Year for Natural Gas Attracts the Bottom-Pickers

It may be tempting to try to catch a rebound, but know what you're getting into first.

With the price of natural gas hitting three-year lows last week, some traders have started trying to bottom-pick. As a result, prices have come off their recent lows as buyers step in and drive prices higher. Those expecting a near-term rebound may be considering

Given the interest that natural gas has garnered during the past week or so, we thought it would be a good time to spotlight UNG. It is true that the exchange-traded fund offers a cheap and accessible way to speculate on movements in short-term natural gas prices. But, there are important caveats to consider before investing.

Suitability United States Natural Gas could be suitable as a tactical investment for those who believe natural gas prices are poised to increase in the short to intermediate term. Because of the extremely specialized exposure of the fund, investors should only consider it for a small position in the satellite portion of a broadly diversified portfolio. Intrepid investors and more-aggressive traders may also look to UNG as a convenient means to speculate on natural gas prices.

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.

For instance, in 2012 UNG dropped 27% while the natural gas spot price actually rose more than 15%. In 2013, UNG gained 9% while the spot price advanced 27%. Last year, UNG's performance closely mirrored the spot price, as it fell 29% compared with the spot price's decline of 31%. Over longer periods, however, the divergence can be exacerbated. For example, over the trailing three-year period through September 2015, UNG saw an annualized loss of 25% while the natural gas spot price had a more modest decline of 8% annually during the same period.

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. During the past one- and three-month periods, UNG is down 9.4% and 12.8%, respectively. In comparison, spot prices fell 7.8% and 10.8% in the same periods.

Remember, funds trading futures contracts will realize disparities from spot because of the mechanics of the futures market. UNG invests in near-month futures contracts, and as each month draws to a close, it has to "roll" its position forward. Effectively, the fund sells its soon-to-expire position and purchases a contract further from expiry to avoid physical delivery. 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. In a contango market, a fund like UNG can suffer heavy losses even as natural gas prices rise, warranting investor caution.

In the context of a broadly diversified investment portfolio, we wouldn't recommend this product for use as a long-term holding of any size given the significant degree to which UNG's returns can lag spot prices over the long run. That said, tracking of spot prices is very good on a day-to-day basis, so those inclined to speculate on the price performance of natural gas over the short term may look to UNG.

Fundamental View Natural gas has come to be viewed as a cleaner, less-expensive alternative to nuclear, hydroelectric, and coal-fired generation sources. An important factor going forward will be the incremental demand from power generators. Morningstar equity analysts are fairly bullish on natural gas prices over the longer term, but some near-term issues could stall the commodity's price rise. In recent years, natural gas supplies ballooned to record high levels, placing downward pressure on prices. Though supplies are no longer quite as high above their historic norms, nor consumption quite as lackluster, prices remain below pre-crash levels.

In the face of continued growth of low-cost supply, Morningstar analysts have reduced their midcycle price estimate for U.S. natural gas by 25%, to $4 per thousand cubic feet. While demand tailwinds from exports and industrial consumption will help balance the domestic gas market, the revised outlook is based on ongoing cost pressures from efficiency gains and excess services capacity--as well as the crowding out of higher-cost production by world-class resources like the Marcellus Shale and associated volumes from oil-rich areas like the Eagle Ford and Permian.

While U.S. gas production is likely to slow in the near term as oil-directed drilling hits the brakes, the wealth of low-cost inventory in areas like the Marcellus points to continued growth through the end of this decade and beyond. The Marcellus is the single-biggest growth driver in our analysts' forecast, adding 14 billion cubic feet per day (75% of incremental volumes) through 2020.

Increased gas consumption should provide an outlet for this abundance of low-cost supply. Recent reforms to Mexico's energy industry should boost demand for gas in that country (most easily supplied through U.S.-to-Mexico pipelines), while liquefied natural gas exports from the United States are set to become a reality starting next year, with a meaningful ramp-up in volumes likely through the end of the decade. U.S. industrial consumption should also increase, given recent greenfield investments and natural gas' cost advantage in petrochemical manufacturing.

Investment vehicles that hold futures contracts, such as UNG, make gaining exposure to natural gas prices relatively cheap and accessible. However, investors should be aware that the returns of futures contracts and the spot price will often decouple, a concept known as basis risk. The futures curve--the prices of contracts at progressively distant expiration dates--can take an upward slope (known as contango) or downward slope (known as backwardation).

When natural gas futures are in a state of contango, as they have been for much of the past five years, then UNG's performance will lag that of the spot price. This is because the next-month contract is priced higher than the expiring contract, causing the strategy to lose money as it rolls its position forward (negative roll yield). Conversely, if natural gas futures are in a state of backwardation, then there will be a performance tailwind when contracts are rolled forward since the next-month contract is cheaper than the expiring contract (positive roll yield).

Portfolio Construction This fund invests primarily in Nymex natural gas futures contracts, which reflect the spot prices for natural gas scheduled to be delivered at Henry Hub in Louisiana. While UNG mostly invests in U.S. contracts, it also reserves the right to buy some contracts on the ICE Futures market as well as over-the-counter swaps. The fund rolls its contracts over from month to month, so it's susceptible to the shape of the futures curve. When it is upward-sloped (that is, longer-dated contracts carry higher prices than contracts near expiration), investors face a headwind in rolling futures, and the reverse when it is downward-sloped.

This exchange-traded product is structured as a limited partnership and has unique tax implications. We'll summarize some of the issues here, but we would recommend consulting your tax professional before diving into these shares. Rather than receiving a summary Form 1099 at the end of the year, investors will receive a Schedule K-1 to report their portion of the company's earnings. So, even if investors do not sell their shares, they may have to pay taxes at a blended rate if there was any gain incurred. Those gains are taxed at a blended rate, of which 60% are considered long-term capital gains and 40% short-term capital gains. Furthermore, because this fund does not ever intend to distribute any funds to its limited partners, most buy-and-hold investors will have to dig into their own pockets for any tax bill.

Fees This fund charges a maximum annual management expense ratio of 0.60%, but it reduces its management fee to 0.50% when its assets are greater than $1 billion. Including fund trading costs, however, the total expense ratio of UNG can increase substantially. For instance, in 2014 the total expense ratio was actually 1.00%.

Alternatives UNG is much more liquid and cheaper than its most similar rival, iPath Bloomberg Natural Gas Subindex Total Return ETN GAZ, which charges 0.75%. As an exchange-traded note, GAZ is merely an unsecured debt obligation and thus privy to much simpler tax treatment. However, a recent proposal regarding the taxation of derivatives put forth in Congress could put ETNs' tax status in jeopardy. As it stands today, investors will be taxed only upon sale. Short-term capital gains rates apply for holding periods less than one year, while long-term capital gains rates apply for periods greater than one year. Remember that ETNs are unsecured debt securities and thus impose credit default risk upon their investors.

Investors concerned about costs associated with the monthly contract-rolling can also consider UNG's sister fund, United States 12 Month Natural Gas UNL, which ladders 12 months' worth of natural gas futures in an attempt to moderate the effects of backwardation and contango. Compared with UNG, UNL charges a higher management fee of 0.75% but has a lower total expense ratio because of lower trading costs (total expense ratio in 2014 was 0.90%).

Those looking to avoid the complexities of the futures market altogether can also take a look at

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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