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(Bloomberg) — A buying spree in ETFs tied to natural gas is spurring concern that the securities risk destabilizing a market that up until now has been the province of energy pros.
Hedge funds and other investors have piled into the exchange-traded funds, known by their tickers BOIL and UNG, seeking to profit off fluctuations in prices for the fuel used for cooking, heating and generating electricity. The funds’ combined net assets are now $2.1 billion, twice the level of just six months ago.
The eye-popping growth for the two funds left them owning about 30% of the front-month futures contracts for gas earlier this week, a ratio many multiples of what’s typical for ETFs tied to commodities futures.
While that isn’t a problem when holdings and prices are stable, any abrupt buying or selling by those ETFs could lead to wild swings for the fuel, exacerbating volatility in a market already beset by more stomach-churning ups and downs than most.
“It’s become dangerously big,” said Gary Cunningham, a director at Tradition Energy, an independent energy risk management and procurement adviser. “If something significant were to happen to it, its positions are so large that they can literally move the market.”
ETFs aren’t supposed to move the market, just trade in line with the underlying asset. They’re designed to be highly liquid securities similar to stocks, ideal for giving investors exposure to commodities like natural gas that usually are traded by industry professionals using more complex futures and options contracts.
But if they get too big, they can start influencing the underlying market instead of just reflecting it. In fact, that’s what happened with natural gas in 2009 when speculators trying to profit from UNG’s need to roll over contracts helped boost volatility to a three-year high as prices surged. The fund was temporarily forced to stop creating new shares because it could no longer expand its holdings in futures markets.
A similar occurrence came in 2020 when oil prices briefly went negative. The United States Oil Fund, a major ETF in the sector, was accused of contributing to market mayhem as it tried to roll over futures contracts amid volatile prices. Regulators eventually ordered the fund to change strategy in the wake of the turmoil.
Read More: For Creators of Giant Oil ETF, Troubles in Market Began a Decade Ago
In the gas market this year, investors put nearly $1.9 billion into BOIL, the ProShares Ultra Bloomberg Natural Gas fund, more than any other US commodity-focused ETF. Its assets jumped almost five-fold from a year ago.
In early June, it held more than a fifth of New York Mercantile Exchange gas futures for July delivery, along with over-the-counter swap gas contracts. On June 7, BOIL started rolling its contracts into September, reducing its position in the front-month futures.
The fund is particularly volatile because it uses leverage to double the daily moves in the underlying gas contracts, a tactic that active traders love because of the opportunity to profit from the swings but which can be dangerous for mom-and-pop buyers unaware of the implications. An investor who bought the fund at last year’s peak in June would have lost 98% of their money if they held it until now.
UNG, formally United States Natural Gas Fund LP, has seen inflows of almost $1.2 billion this year. The fund holds almost 10% of July gas contracts.
Neither ETF is designed for buy-and-hold investors because they’re structured in a way that will almost always lose money. They must roll their contracts forward as the front-month expires, and since longer-term deliveries are typically pricier, that erodes returns.
Flows into gas ETFs surged during the US winter months as predominantly mild temperatures curbed heating demand, sending prices for the fuel plunging from August’s 14-year highs. While the buying appetite has since diminished, flows have remained positive for six straight months.
On a daily basis, BOIL flows have tended to move in an inverse direction to prices, meaning investors are net buyers when prices are down and net sellers when prices are up. That’s because some traders seem to be using BOIL as a hedging tool, so they need to add more shares when prices fall as a way to maintain their hedge’s value, according to James Seyffart, a Bloomberg Intelligence analyst.
“You also have traders and people trying to time the market that will pour in as the price collapses, trying to hit a jackpot moment when it flies higher,” Seyffart said. “So if natural gas turns around you will see outflows from this product, which will be traders taking profits and hedgers taking off some of the hedge they no longer need.”
There’s limited transparency into who exactly or even what kinds of investors hold the ETFs, and their issuers declined to comment on ownership.
UNG’s issuer, United States Commodity Funds, said the inflows to the fund are consistent with historical patterns. “When prices are volatile and/or low, we believe traders see potential opportunities,” Chief Marketing Officer Katie Rooney said in an email.
John Hyland, a former executive who oversaw commodity-linked products including USO and UNG as chief investment officer at the firm, estimates that more than 80% of gas ETFs are held by hedge funds and other professionals, with retail investors almost certainly a “small minority of the shareholder base.”
“I always joked that 80% of our shares are held by firms having a mailing address in Connecticut, a tax domicile in the Cayman Islands, and a Greek or Roman god in their name,” Hyland said in an email. “But I am not exactly sure what they do for a living.”
Investors in gas ETFs risk making the commodity, already the “king of volatility,” even more prone to swings that exacerbate the trends dictated by supply and demand fundamentals, according to Robert Yawger, director of the futures division at Mizuho Securities USA.
“It’s a herd mentality,” Yawger said.
–With assistance from Isabelle Lee.
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