I'm learning. I apologize to anyone who took my advice and bought UNG. It has gone up, so why am I apologizing? Because it hasn't gone up nearly as much as the natural gas spot price has. This is because of contango. I am actually now recommending that you take your small gains and get out of UNG, because it is likely to actually go down, even as the natural gas spot price goes up.

I will be posting this to google finance soon, but only after I sell my shares... for readers of my blog, you get the scoop early:

As far as I know... here is how this works (corrections will be happily received):

Contango indicates a situation when far month prices are higher than near month prices, and the futures curve slopes upwards.

A small amount of contango is normal. Future prices are normally higher than spot prices because of (1) the cost of carry which includes (1a) storage costs (1b) lost interest on capital invested, and (2) a small amount of inflation.

When the contango spread exceeds these costs, it is usually arbitraged away by big players who can take delivery. They buy the near month, and sell a future month, and pocket the difference. When the delivery month comes around (the near month), they take supply off of the market, and store it, delivering it later as promised and required.

Buying the near month brings up spot and near month prices. Selling the far month lowers future prices. This relieves the contango situation.

However, there is a fly in the ointment. Arbitrage can only occur while there is enough storage available, and enough arbitragers out there doing it (relative to the amount of speculators creating and exacerbating the contango). If storage becomes scarce, arbitrage is limited. This causes both the spot and the futures price to actually fall. Two things cause this: first, the demand from arbitragers falls away. Second, supply coming onto the market must be sold, it cannot be stored, and that depresses the price. The falling spot price drags down the entire futures curve.

I don't know the current situation well enough, but I hear that there is a lot of supply, low storage, and lots and lots of speculators (represented by this ETF) relative to the amount of arbitrage available... that would indicate that a steep contango will continue.

ETFs like UNG and USO usually suffer losses each month as they roll over into the next month's futures contracts (which are priced somewhat higher). UNG rolls 2 weeks before the last trading day, which is three business days before the first business day of the delivery month. So that spread in price is significant. It is even worse during contango when the futures curve is steep. And it can persist for a long time when storage is exhausted.

ETFs like UNG and USO lose even more money when there is a lot of interest in them (as there is currently), because when they roll over the huge amount of selling the near month and buying into the next month actually exacerbates the contango.

One month ago, the ratio of UNG to NG was 3.917. Today it is 3.702. That's a loss of more than 5% in just one month. If the price of Natural Gas goes up along the predicted futures curve at a rate of about 3-4% per month, and UNG continues to fall off of that curve at a rate of >5% per month due to contango issues, UNG will actually fall even as the NG spot price rises.

Yes, Natural Gas is very cheap. UNG is a bad way to play it. I'm not excited about the produers yet because I don't see natural gas going up very quickly. Right now, I would play this by buying utility companies that use natural gas. Their costs are low, so they should show some nice profits in the next two quarters.