Trader Talk

Published: Thursday, 9 Jul 2009 | 3:58 PM ET

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Bob Pisani is off today, this was written by CNBC producer Robert Hum

Earlier this week the big natural gas ETF, the U.S. Natural Gas Fund (UNG), announced that it was suspending the issuance of new shares.

Why did this happen?

The fund’s provider has run out of its previously-authorized allocation of shares due to the recent skyrocketing demand for the ETF. Typically, baskets of shares are created by the ETF’s provider to help meet the demand from investors who want to buy shares of the fund.

Take a look at what’s happened over just the last 3 months. Average daily trading volume in the UNG has increased more than 10 times while assets under management have grown almost 5 fold!

So how big has the U.S. Natural Gas Fund become?

The UNG is still dwarfed by the biggest commodity ETF, the SPDR Gold Trust (GLD), which has over $33 billion in assets. However, the UNG has become more than double the size of the leading oil-backed ETF, the U.S. Oil Fund (USO), which has just under $1.9 billion in assets.

Keep in mind, the surge in assets truly reflects the enormous investor appetite for the UNG ETF, rather than the appreciation of its underlying security. Remember that natural gas prices are actually DOWN over 70 percent over the past year and are hovering near a 7-year low. Just imagine how much more the assets would have potentially grown if natural gas prices had risen back to their levels from last summer!

As a result of the surging demand, the fund has sought approval from the SEC to create an additional 1 billion new shares – a dramatic increase from the current 200 million shares it has already issued in the open market. No decision from the SEC has been made yet, however, and there are no indications yet on when approval will be granted.

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Why this formality?

Unlike equity ETFs, commodity ETFs – which often hold commodity futures contracts – must receive SEC approval before the fund can increase the number of shares it can issue for trading on the open market.

In the meantime, trading of existing UNG shares continues normally. However, if the fund is forced to continue its share issuance suspension over a prolonged period, investors may find the ETF’s tracking error could widen. In this case, the ETF could begin trading at a premium to natural gas prices because of 1) the limited number of shares available and 2) the continued strong demand for the ETF. If this does occur, the fund’s share price would essentially reflect the supply/demand forces of the shares, rather the actual price of the natural gas futures that it is designed to track – a potential problem indeed!

Additionally, if the fund does end up receiving approval to issue 1 billion new shares, many are worried about the implications and effects that action will have on the natural gas futures market. Some critics have accused commodity ETFs of fueling the volatility and distorting prices of commodity futures prices. They suggest that this happens as funds amass greater holdings of bullion or commodity future contracts that they track to keep up with investors’ interest as more money gets invested into the funds.

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