Natural gas prices are a hot topic. Some have accused natural gas prices of being manipulated. Others are making a killing trading the action in natural gas prices. Permabulls get hit and permabears get hit from natural gas prices and movements in underlying assets. The most popular way in which many novice investors gain exposure to natural gas prices is through the United States Natural Gas ETF (UNG).

This natural gas ETF had rallied from $5.20 to $6.05 in just 5 trading days, on the back of bitter cold temperatures throughout the United States. Then, it gave much of it back over the last two days. While this is one heck of rally, and makes for a great trade, there are people who have no idea why the ETF appears to be up 300% today.

Folks, lets make it simple. It went through a reverse split.

The reverse split will increase the price per share of the fund with a proportionate decrease in the number of shares outstanding. In a 1 for 4 reverse split, every four pre-split shares held by a shareholder will result in the receipt of one post-split share, which will be priced four times higher than the value pre-split share. (For example if you hold 100 shares of UNG priced at $10.00 each, then after the reverse split you will hold 25 shares valued at $40.00 each.) Thus, the reverse split does not change the value of a shareholder’s investment. Again, the ticker symbol for the fund will remain the same even with the new change in price. The only change on paper for the fund is that it will be issued a new CUSIP number, which identifies the product on exchanges.

There are two more considerations to think about during this split. What happens with fractional shares, and what happens to owners of options contracts.

Reverse Splits Could Result in Fractional Shares

For those shareholders who hold quantities of shares that are not a whole number with an exact multiple of the reverse split ratio, the reverse split will result in the creation of a fractional share. This will affect any shareholder who does not hold a number of shares that is a multiple of four. After the reverse split occurs fractional shares will be redeemed for cash and sent to your broker of record, generally within two weeks post-split. The major issue associated with such a move is that it forces shareholders to realize either gains or losses, which could result in a taxable event for those shareholders, in addition to having a potential loss on investment if prices are below where they were purchased. Given that the markets are approaching all time highs, a loss is quite possible in UNG. One way to mitigate this is to purchase more shares to round out your UNG holdings to a multiple of four, or to sell an appropriate number of shares to round out the holdings.

What About Options Contracts On UNG?

For those traders who may be holding options on UNG, this split will affect your contract, albeit minimally. Once the fund conducts the reverse split, the contract undergoes an adjustment that is commonly known as “being made whole”, which means the option contract is modified accordingly so that options holders are neither negatively nor positively affected by the split. While we know the reverse split will adjust the price of the underlying shares of the option, the option will be adjusted so that the changes in price due to the split do not affect the value of the option.

So if there is positive or negative effect on the option value, just how much will the option be worth post-split? You actually don’t need to worry about such things, because the options clearing corporation automatically adjusts the price to maintain the option market. However, for those who want an estimate of what the UNG option will be worth, the calculation is simple. Each UNG option contract is (usually) in control of 100 shares of UNG at some predetermined strike price. To find the new share coverage of the option after the split, all you do is simply take the split ratio and multiply by the old share coverage (normally 100 shares). To find the new strike price, take the old strike price and divide by the split ratio.

Let’s look at an example of a call option contract for 100 shares of UNG at a strike of $5.00. Since the split is 1 for 4 we divide $5.00 by 1/4, generating a new strike price of $20.00. The option will now cover 25 shares because we multiply 100 by 1/4. Thus, your new call option contract (which will expire on the same day as originally scheduled) will be good for a purchase of 25 shares of UNG for $500. On your brokerage account, the contract may be adjusted to read “UNG1” or similar and still state it is worth 100 shares at the original price, but for redemption purposes, the contract would be redeemed for 25 shares at the post-split price.

UNG an natural gas prices as an investment

We do not recommend a long-term investment in this ETF.

Why? You see, UNG, while being tied to natural gas prices, actually holds natural gas futures contracts and swaps. This makes it volatile and can swing with short-term movement in natural gas prices, such as the massive gains seen in the last few trading days. Now, the underlying benchmark for the natural gas futures contracts in which it has exposure are those in on the NYMEX.

Here is the problem. UNG is severely prone to negative impacts from contango given that it is forced to buy the near month contract. On NASDAQ, you will see that the description indicates:

“If the near month contract is within two weeks of expiration, the Benchmark will be the next month contract to expire. The natural gas contract is natural gas delivered at the Henry Hub, Louisiana.”

Therefore, since UNG is selling the front month to buy the forward month, depending on where the contracts are priced, UNG can suffer. Worst case scenario? The futures contracts are consistently priced higher.

As you can see from the current prices, this won’t be an issue in the next couple of months. But let us assume that these prices were held constant, and we were in September 2018 at $2.82. If the forward month is priced higher, UNG loses. By January 2019, at $3.11, UNG will have lost $0.29 to its contract activity.

Of course, in reality, if natural gas prices are consistently rising, then this issue doesn’t have a massive negative consequence. However, if pricing is stagnant, or in a defined range, then this negative impact will be felt. This makes UNG a terrible long-term hold, as the investment can degrade even if natural gas prices remain constant.

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