Natural gas prices are hovering around a decade low as the gas market lies in a persistent supply glut. Exchange traded fund investors, though, may still hedge against natural gas, but they will have to be smart about it.

Over the last couple of years, new technology and refinement techniques, especially in North American shale formations and the rise in hydraulic fracturing, or “fracking,” have contributed to the supply glut we see in the natural gas market today, writes ETF analyst Abraham Bailin for Morningstar.

In the last five years, natural gas inventories have averaged 1,537 billion cubic feet, but gas storage now sits at around 2,437 bcf. It should be noted that natural gas is largely an immobile and regional energy source since the infrastructure for moving liquid natural gas has not been as fully developed as it is for crude oil or coal.

Natural gas prices currently sit at around $1.96. [Natural Gas ETF Losing Its Heat; Futures Dip Below $2]

Natural gas-related ETFs are all futures based. As such, the futures-based ETFs will be subject to the costs that come with rolling contracts – when a contract reaches maturity, the fund would roll the contract or sell the near expiry contract and buy a later-dated futures contract. In the case of natural gas funds, the supply glut has depressed spot prices, making later-dated contracts more expensive, or simply known as a state of “contango.”

The negative effects of contango can exacerbate loses within an ETF as the fund sells a contracts and rolls to a more expensive contract further out on the curve. For instance, the United States Natural Gas Fund (NYSEArca: UNG) has lost 46% over 2011, whereas U.S. natural gas wellhead prices fell 33%.

To help mitigate the effects of contango, the United States 12-Month Natural Gas Fund (NYSEArca: UNL) was created. UNL holds assets in the first 12 months of futures contracts – contracts further down the curve diminishes the negative roll-yield. Accordingly, UNL only fell 39% in 2011.

Bailin argues that by using UNG and UNL together, an investor can benefit from the persistent level of contango, with less volatility.

“Those inclined to believe that natural gas prices are likely to remain low until the supply glut abates can capture a contango-driven gain by shorting UNG,” Bailin said. “At the same time, establishing a long position in UNL will hedge out much of the return associated with movements of the spot price. If one were to have invested in such a strategy since January 2010, when both products were available for trade, he would have done quite well. Spreading UNG against UNL and rebalancing to 50/50 on a monthly basis received a 5% annualized return.”

“The strategy’s volatility, as measured by standard deviation, would have been a mere 2%,” Bailin added.

United States Natural Gas Fund

For more information on the natural gas market, visit our natural gas category.

Max Chen contributed to this article.

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