Natural Gas vs Oil Pair Trade

There seems to be a nice pair trade in natural gas versus oil. Since they are both energy there is a natural equivalence of six units of natural gas to one unit of oil. Each measured appropriately.

Natural gas has gotten cheap compared to oil. That happens for many reasons one of which is that they have slightly different markets. Oil is an international commodity, shipped all over the world, while natural gas is pulled out of the ground and fed into pipelines that go to manufacturing plants all over the midwest and homes in the northeast.

If you believed that natural gas will move back up compared to oil, you could buy UNG and short USO or buy UNG calls and USO puts. UNG is the natural gas ETF and USO is the oil ETF.

Here there are subtleties too. The oil complex ETFs actually hold futures contracts for the near month. That means that every month they have to roll those contracts forward to the next month. If the futures curve is flat, there is no expense or profit in the roll. If the futures curve is upward sloping (contango) the ETF has to pay up to roll forward and that can have a large impact on the return of the fund. Of course, if the curve is downward sloping (backwardation) the fund makes money on the roll.

The upshot of this is that you are not really buying spot oil or natural gas, rather have a position in the futures which the roll can affect significantly.

Another problem is that UNG has grown so large that it cannot hold enough futures for all the money that has come into the fund. It has entered into swaps contracts with counterparties to buy the gas. So now there is counterparty risk and it is unclear what effect the roll will have on its returns.

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