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Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x | Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
for the quarterly period ended June 30, 2011.
OR
¨ | Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
for the transition period from to .
Commission File Number: 001-34535
United States 12 Month Natural Gas Fund, LP
(Exact name of registrant as specified in its charter)
Delaware | 26-0431733 | |
(State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) |
1320 Harbor Bay Parkway, Suite 145
Alameda, California 94502
(Address of principal executive offices) (Zip code)
(510) 522-9600
(Registrants telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Large accelerated filer |
¨ |
Accelerated filer |
¨ | |||
Non-accelerated filer |
x (Do not check if a smaller reporting company) |
Smaller reporting company |
¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
Table of Contents
UNITED STATES 12 MONTH NATURAL GAS FUND, LP
Table of Contents
Page | ||||||
Item 1. | Condensed Financial Statements. | 1 | ||||
Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations. | 16 | ||||
Item 3. | Quantitative and Qualitative Disclosures About Market Risk. | 36 | ||||
Item 4. | Controls and Procedures. | 38 | ||||
Item 1. | Legal Proceedings. | 38 | ||||
Item 1A. | Risk Factors. | 38 | ||||
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds. | 39 | ||||
Item 3. | Defaults Upon Senior Securities. | 39 | ||||
Item 4. | Removed and Reserved. | 39 | ||||
Item 5. | Other Information. | 39 | ||||
Item 6. | Exhibits. | 39 |
Table of Contents
Item 1. Condensed Financial Statements.
Index to Condensed Financial Statements
1
Table of Contents
United States 12 Month Natural Gas Fund, LP
Condensed Statements of Financial Condition
At June 30, 2011 (Unaudited) and December 31, 2010
June 30, 2011 | December 31, 2010 | |||||||
Assets |
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Cash and cash equivalents (Note 5) |
$ | 32,583,105 | $ | 30,313,275 | ||||
Equity in UBS Securities LLC trading accounts: |
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Cash |
4,761,743 | 6,966,692 | ||||||
Unrealized loss on open commodity futures contracts |
(1,458,490 | ) | (2,175,060 | ) | ||||
Receivable from General Partner |
73,573 | 151,689 | ||||||
Dividend receivable |
255 | 1,063 | ||||||
Other assets |
799 | 558 | ||||||
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Total assets |
$ | 35,960,985 | $ | 35,258,217 | ||||
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Liabilities and Partners Capital |
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Investment payable |
$ | 12 | $ | | ||||
Professional fees payable |
99,188 | 205,005 | ||||||
General Partner management fees payable (Note 3) |
22,812 | 23,857 | ||||||
Brokerage commissions payable |
4,485 | 4,685 | ||||||
Other liabilities |
2,341 | 2,657 | ||||||
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Total liabilities |
128,838 | 236,204 | ||||||
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Commitments and Contingencies (Notes 3, 4 and 5) |
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Partners Capital |
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General Partner |
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Limited Partners |
35,832,147 | 35,022,013 | ||||||
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Total Partners Capital |
35,832,147 | 35,022,013 | ||||||
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Total liabilities and partners capital |
$ | 35,960,985 | $ | 35,258,217 | ||||
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Limited Partners units outstanding |
1,100,000 | 1,000,000 | ||||||
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Net asset value per unit |
$ | 32.57 | $ | 35.02 | ||||
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Market value per unit |
$ | 32.66 | $ | 34.97 | ||||
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See accompanying notes to condensed financial statements.
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United States 12 Month Natural Gas Fund, LP
Condensed Schedule of Investments (Unaudited)
At June 30, 2011
Number of Contracts |
Loss on Open Commodity Contracts |
% of Partners Capital |
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Open Futures Contracts - Long |
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United States Contracts |
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NYMEX Natural Gas Futures NG August 2011 contracts, expiring July 2011 |
64 | $ | (200,740 | ) | (0.56 | ) | ||||||
NYMEX Natural Gas Futures NG September 2011 contracts, expiring August 2011 |
64 | (182,240 | ) | (0.51 | ) | |||||||
NYMEX Natural Gas Futures NG October 2011 contracts, expiring September 2011 |
64 | (181,520 | ) | (0.51 | ) | |||||||
NYMEX Natural Gas Futures NG November 2011 contracts, expiring October 2011 |
64 | (144,970 | ) | (0.40 | ) | |||||||
NYMEX Natural Gas Futures NG December 2011 contracts, expiring November 2011 |
64 | (149,900 | ) | (0.42 | ) | |||||||
NYMEX Natural Gas Futures NG January 2012 contracts, expiring December 2011 |
65 | (178,550 | ) | (0.50 | ) | |||||||
NYMEX Natural Gas Futures NG February 2012 contracts, expiring January 2012 |
64 | (190,310 | ) | (0.53 | ) | |||||||
NYMEX Natural Gas Futures NG March 2012 contracts, expiring February 2012 |
64 | (34,150 | ) | (0.10 | ) | |||||||
NYMEX Natural Gas Futures NG April 2012 contracts, expiring March 2012 |
64 | (43,400 | ) | (0.12 | ) | |||||||
NYMEX Natural Gas Futures NG May 2012 contracts, expiring April 2012 |
64 | (41,620 | ) | (0.12 | ) | |||||||
NYMEX Natural Gas Futures NG June 2012 contracts, expiring May 2012 |
64 | (16,230 | ) | (0.04 | ) | |||||||
NYMEX Natural Gas Futures NG July 2012 contracts, expiring June 2012 |
65 | (94,860 | ) | (0.26 | ) | |||||||
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Total Open Futures Contracts |
770 | $ | (1,458,490 | ) | (4.07 | ) | ||||||
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Principal Amount |
Market Value |
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Cash Equivalents |
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United States - Money Market Funds |
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Fidelity Institutional Government Portfolio - Class I |
$ | 7,508,599 | $ | 7,508,599 | 20.95 | |||||||
Goldman Sachs Financial Square Funds - Government Fund - Class SL |
2,501,931 | 2,501,931 | 6.98 | |||||||||
Morgan Stanley Institutional Liquidity Fund - Government Portfolio |
22,007,007 | 22,007,007 | 61.42 | |||||||||
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Total Cash Equivalents |
$ | 32,017,537 | 89.35 | |||||||||
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See accompanying notes to condensed financial statements.
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Table of Contents
United States 12 Month Natural Gas Fund, LP
Condensed Statements of Operations (Unaudited)
For the three and six months ended June 30, 2011 and 2010
Three months ended June 30, 2011 |
Three months ended June 30, 2010 |
Six months ended June 30, 2011 |
Six months ended June 30, 2010 |
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Income |
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Gain (loss) on trading of commodity futures contracts: |
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Realized loss on closed positions |
$ | (1,127,760 | ) | $ | (2,761,400 | ) | $ | (3,068,370 | ) | $ | (2,772,650 | ) | ||||
Change in unrealized gain (loss) on open positions |
(799,220 | ) | 4,573,760 | 716,570 | (4,783,520 | ) | ||||||||||
Dividend income |
880 | 3,342 | 3,081 | 4,872 | ||||||||||||
Interest income |
123 | 423 | 227 | 775 | ||||||||||||
Other income |
1,000 | 3,000 | 5,000 | 4,000 | ||||||||||||
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Total income (loss) |
(1,924,977 | ) | 1,819,125 | (2,343,492 | ) | (7,546,523 | ) | |||||||||
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Expenses |
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General Partners management fees (Note 3) |
69,828 | 62,548 | 128,076 | 114,795 | ||||||||||||
Professional fees |
49,868 | 36,900 | 99,188 | 188,500 | ||||||||||||
Brokerage commissions |
1,712 | 4,193 | 4,378 | 6,213 | ||||||||||||
Other expenses |
3,352 | 7,290 | 6,074 | 9,867 | ||||||||||||
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Total expenses |
124,760 | 110,931 | 237,716 | 319,375 | ||||||||||||
Expense waiver (Note 3) |
(35,903 | ) | (30,482 | ) | (73,573 | ) | (169,020 | ) | ||||||||
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Net expenses |
88,857 | 80,449 | 164,143 | 150,355 | ||||||||||||
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Net income (loss) |
$ | (2,013,834 | ) | $ | 1,738,676 | $ | (2,507,635 | ) | $ | (7,696,878 | ) | |||||
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Net income (loss) per limited partnership unit |
$ | (1.70 | ) | $ | 1.82 | $ | (2.45 | ) | $ | (11.41 | ) | |||||
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Net income (loss) per weighted average limited partnership unit |
$ | (1.81 | ) | $ | 2.05 | $ | (2.44 | ) | $ | (9.87 | ) | |||||
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Weighted average limited partnership units outstanding |
1,115,385 | 846,154 | 1,025,967 | 780,110 | ||||||||||||
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See accompanying notes to condensed financial statements.
4
Table of Contents
United States 12 Month Natural Gas Fund, LP
Condensed Statement of Changes in Partners Capital (Unaudited)
For the six months ended June 30, 2011
General Partner | Limited Partners | Total | ||||||||||
Balances, at December 31, 2010 |
$ | | $ | 35,022,013 | $ | 35,022,013 | ||||||
Addition of 300,000 partnership units |
| 10,130,630 | 10,130,630 | |||||||||
Redemption of 200,000 partnership units |
| (6,812,861 | ) | (6,812,861 | ) | |||||||
Net loss |
| (2,507,635 | ) | (2,507,635 | ) | |||||||
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Balances, at June 30, 2011 |
$ | | $ | 35,832,147 | $ | 35,832,147 | ||||||
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Net Asset Value Per Unit: |
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At December 31, 2010 |
$ | 35.02 | ||||||||||
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At June 30, 2011 |
$ | 32.57 | ||||||||||
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See accompanying notes to condensed financial statements.
5
Table of Contents
United States 12 Month Natural Gas Fund, LP
Condensed Statements of Cash Flows (Unaudited)
For the six months ended June 30, 2011 and 2010
Six months ended June 30, 2011 |
Six months ended June 30, 2010 |
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Cash Flows from Operating Activities: |
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Net loss |
$ | (2,507,635 | ) | $ | (7,696,878 | ) | ||
Adjustments to reconcile net loss to cash used in operating activities: |
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Decrease (increase) in commodity futures trading account - cash |
2,204,949 | (2,328,109 | ) | |||||
Unrealized gain (loss) on futures contracts |
(716,570 | ) | 4,783,520 | |||||
(Increase) decrease in receivable from General Partner |
78,116 | (32,342 | ) | |||||
(Increase) decrease in dividend receivable and other assets |
567 | (1,261 | ) | |||||
Increase in investment payable |
12 | | ||||||
Increase (decrease) in professional fees payable |
(105,817 | ) | 47,700 | |||||
Increase (decrease) in General Partner management fees payable |
(1,045 | ) | 5,246 | |||||
Increase (decrease) in brokerage commissions payable |
(200 | ) | 885 | |||||
Increase (decrease) in other liabilities |
(316 | ) | 1,227 | |||||
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Net cash used in operating activities |
(1,047,939 | ) | (5,220,012 | ) | ||||
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Cash Flows from Financing Activities: |
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Addition of partnership units |
10,130,630 | 12,642,174 | ||||||
Redemption of partnership units |
(6,812,861 | ) | (12,932,599 | ) | ||||
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Net cash provided by (used in) financing activities |
3,317,769 | (290,425 | ) | |||||
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Net Increase (Decrease) in Cash and Cash Equivalents |
2,269,830 | (5,510,437 | ) | |||||
Cash and Cash Equivalents, beginning of period |
30,313,275 | 32,056,391 | ||||||
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Cash and Cash Equivalents, end of period |
$ | 32,583,105 | $ | 26,545,954 | ||||
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See accompanying notes to condensed financial statements.
6
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United States 12 Month Natural Gas Fund, LP
Notes to Condensed Financial Statements
For the period ended June 30, 2011 (Unaudited)
NOTE 1 - ORGANIZATION AND BUSINESS
The United States 12 Month Natural Gas Fund, LP (US12NG) was organized as a limited partnership under the laws of the state of Delaware on June 27, 2007. US12NG is a commodity pool that issues limited partnership units (units) that may be purchased and sold on the NYSE Arca, Inc. (the NYSE Arca). US12NG will continue in perpetuity, unless terminated sooner upon the occurrence of one or more events as described in its Amended and Restated Agreement of Limited Partnership dated as of October 30, 2009 (the LP Agreement). The investment objective of US12NG is for the daily changes in percentage terms of its units net asset value to reflect the daily changes in percentage terms of the spot price of natural gas delivered at the Henry Hub, Louisiana, as measured by the changes in the average of the prices of 12 futures contracts for natural gas traded on the New York Mercantile Exchange (the NYMEX), consisting of the near month contract to expire and the contracts for the following 11 months for a total of 12 consecutive months contracts, except when the near month contract is within two weeks of expiration, in which case it will be measured by the futures contract that is the next month contract to expire and the contracts for the following 11 consecutive months, less US12NGs expenses. When calculating the daily movement of the average price of the 12 contracts, each contract month is equally weighted. It is not the intent of US12NG to be operated in a fashion such that the net asset value will equal, in dollar terms, the spot price of natural gas or any particular futures contract based on natural gas. United States Commodity Funds LLC (USCF) believes that it is not practical to manage the portfolio to achieve such an investment goal when investing in Futures Contracts (as defined below) and Other Natural Gas-Related Investments (as defined below). US12NG accomplishes its objective through investments in futures contracts for natural gas, crude oil, heating oil, gasoline and other petroleum-based fuels that are traded on the NYMEX, ICE Futures or other U.S. and foreign exchanges (collectively, Futures Contracts) and other natural gas-related investments such as cash-settled options on Futures Contracts, forward contracts for natural gas, cleared swap contracts and over-the-counter transactions that are based on the price of natural gas, crude oil and other petroleum-based fuels, Futures Contracts for natural gas and indices based on the foregoing (collectively, Other Natural Gas-Related Investments). As of June 30, 2011, US12NG held 770 Futures Contracts for natural gas traded on the NYMEX.
US12NG commenced investment operations on November 18, 2009 and has a fiscal year ending on December 31. USCF is responsible for the management of US12NG. USCF is a member of the National Futures Association (the NFA) and became a commodity pool operator registered with the Commodity Futures Trading Commission (the CFTC) effective December 1, 2005. USCF is also the general partner of the United States Oil Fund, LP (USOF), the United States Natural Gas Fund, LP (USNG), the United States 12 Month Oil Fund, LP (US12OF), the United States Gasoline Fund, LP (UGA) and the United States Heating Oil Fund, LP (USHO), which listed their limited partnership units on the American Stock Exchange (the AMEX) under the ticker symbols USO on April 10, 2006, UNG on April 18, 2007, USL on December 6, 2007, UGA on February 26, 2008 and UHN on April 9, 2008, respectively. As a result of the acquisition of the AMEX by NYSE Euronext, each of USOFs, USNGs, US12OFs, UGAs and USHOs units commenced trading on the NYSE Arca on November 25, 2008. USCF is also the general partner of the United States Short Oil Fund, LP (USSO) and the United States Brent Oil Fund, LP (USBO), which listed their limited partnership units on the NYSE Arca under the ticker symbols DNO on September 24, 2009 and BNO on June 2, 2010, respectively. USCF is also the sponsor of the United States Commodity Index Fund (USCI), a series of the United States Commodity Index Funds Trust (the Trust) which listed its units on the NYSE Arca under the ticker symbol USCI on August 10, 2010. USCF has also filed a registration statement to register units of the United States Metals Index Fund, the United States Agriculture Index Fund and the United States Copper Index Fund, three additional series of the Trust.
US12NG issues units to certain authorized purchasers (Authorized Purchasers) by offering baskets consisting of 100,000 units (Creation Baskets) through ALPS Distributors, Inc., as the marketing agent (the Marketing Agent). The purchase price for a Creation Basket is based upon the net asset value of a unit calculated shortly after the close of the core trading session on the NYSE Arca on the day the order to create the basket is properly received.
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In addition, from July 1, 2011 to December 31, 2011, Authorized Purchasers pay US12NG a $350 fee for each order placed to create one or more Creation Baskets or to redeem one or more baskets consisting of 100,000 units (Redemption Baskets); prior to July 1, 2011, this fee was $1,000. Units may be purchased or sold on a nationally recognized securities exchange in smaller increments than a Creation Basket or Redemption Basket. Units purchased or sold on a nationally recognized securities exchange are not purchased or sold at the net asset value of US12NG but rather at market prices quoted on such exchange.
In November 2009, US12NG initially registered 30,000,000 units on Form S-1 with the U.S. Securities and Exchange Commission (the SEC). On November 18, 2009, US12NG listed its units on the NYSE Arca under the ticker symbol UNL. On that day, US12NG established its initial net asset value by setting the price at $50.00 per unit and issued 200,000 units in exchange for $10,000,000. US12NG also commenced investment operations on November 18, 2009 by purchasing Futures Contracts traded on the NYMEX based on natural gas. As of June 30, 2011, US12NG had registered a total of 30,000,000 units.
The accompanying unaudited condensed financial statements have been prepared in accordance with Rule 10-01 of Regulation S-X promulgated by the SEC and, therefore, do not include all information and footnote disclosure required under accounting principles generally accepted in the United States of America (GAAP). The financial information included herein is unaudited; however, such financial information reflects all adjustments which are, in the opinion of USCF, necessary for the fair presentation of the condensed financial statements for the interim period.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Revenue Recognition
Commodity futures contracts, forward contracts, physical commodities and related options are recorded on the trade date. All such transactions are recorded on the identified cost basis and marked to market daily. Unrealized gains or losses on open contracts are reflected in the condensed statement of financial condition and represent the difference between the original contract amount and the market value (as determined by exchange settlement prices for futures contracts and related options and cash dealer prices at a predetermined time for forward contracts, physical commodities, and their related options) as of the last business day of the year or as of the last date of the condensed financial statements. Changes in the unrealized gains or losses between periods are reflected in the condensed statement of operations. US12NG earns interest on its assets denominated in U.S. dollars on deposit with the futures commission merchant at the overnight Federal Funds Rate less 32 basis points. In addition, US12NG earns income on funds held at the custodian at prevailing market rates earned on such investments.
Brokerage Commissions
Brokerage commissions on all open commodity futures contracts are accrued on a full-turn basis.
Income Taxes
US12NG is not subject to federal income taxes; each partner reports his/her allocable share of income, gain, loss deductions or credits on his/her own income tax return.
In accordance with GAAP, US12NG is required to determine whether a tax position is more likely than not to be sustained upon examination by the applicable taxing authority, including resolution of any tax related appeals or litigation processes, based on the technical merits of the position. US12NG files an income tax return in the U.S. federal jurisdiction, and may file income tax returns in various U.S. states. US12NG is not subject to income tax return examinations by major taxing authorities for years before 2007 (year of inception). The tax benefit recognized is measured as the largest amount of benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. De-recognition of a tax benefit previously recognized results in US12NG recording a tax liability that reduces net assets. However, US12NGs conclusions regarding this policy may be subject to review and adjustment at a later date based on factors including, but not limited to, on-going analyses of and changes to tax laws, regulations and interpretations thereof. US12NG recognizes interest accrued related to unrecognized tax benefits and penalties related to unrecognized tax benefits in income tax fees payable, if assessed. No interest expense or penalties have been recognized as of and for the period ended June 30, 2011.
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Creations and Redemptions
Authorized Purchasers may purchase Creation Baskets or redeem Redemption Baskets only in blocks of 100,000 units at a price equal to the net asset value of the units calculated shortly after the close of the core trading session on the NYSE Arca on the day the order is placed.
US12NG receives or pays the proceeds from units sold or redeemed within three business days after the trade date of the purchase or redemption. The amounts due from Authorized Purchasers are reflected in US12NGs condensed statement of financial condition as receivable for units sold, and amounts payable to Authorized Purchasers upon redemption are reflected as payable for units redeemed.
Partnership Capital and Allocation of Partnership Income and Losses
Profit or loss shall be allocated among the partners of US12NG in proportion to the number of units each partner holds as of the close of each month. USCF may revise, alter or otherwise modify this method of allocation as described in the LP Agreement.
Calculation of Net Asset Value
US12NGs net asset value is calculated on each NYSE Arca trading day by taking the current market value of its total assets, subtracting any liabilities and dividing the amount by the total number of units issued and outstanding. US12NG uses the closing price for the contracts on the relevant exchange on that day to determine the value of contracts held on such exchange.
Net Income (Loss) per Unit
Net income (loss) per unit is the difference between the net asset value per unit at the beginning of each period and at the end of each period. The weighted average number of units outstanding was computed for purposes of disclosing net income (loss) per weighted average unit. The weighted average units are equal to the number of units outstanding at the end of the period, adjusted proportionately for units redeemed based on the amount of time the units were outstanding during such period. There were no units held by USCF at June 30, 2011.
Offering Costs
Offering costs incurred in connection with the registration of additional units after the initial registration of units are borne by US12NG. These costs include registration fees paid to regulatory agencies and all legal, accounting, printing and other expenses associated with such offerings. These costs are accounted for as a deferred charge and thereafter amortized to expense over twelve months on a straight-line basis or a shorter period if warranted.
Cash Equivalents
Cash equivalents include money market funds and overnight deposits or time deposits with original maturity dates of three months or less.
Reclassification
Certain amounts in the accompanying condensed financial statements were reclassified to conform with the current presentation.
Use of Estimates
The preparation of condensed financial statements in conformity with GAAP requires US12NGs management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed financial statements, and the reported amounts of the revenue and expenses during the reporting period. Actual results may differ from those estimates and assumptions.
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NOTE 3 - FEES PAID BY THE FUND AND RELATED PARTY TRANSACTIONS
USCF Management Fee
Under the LP Agreement, USCF is responsible for investing the assets of US12NG in accordance with the objectives and policies of US12NG. In addition, USCF has arranged for one or more third parties to provide administrative, custody, accounting, transfer agency and other necessary services to US12NG. For these services, US12NG is contractually obligated to pay USCF a fee, which is paid monthly, equal to 0.75% per annum of average daily net assets. Since inception through April 30, 2010, USCF was charging US12NG a management fee at a reduced rate of 0.60% per annum of average daily net assets. Effective May 1, 2010, USCF resumed charging its standard rate of 0.75% per annum of average daily net assets. The difference of 0.15% per annum of average daily net assets since inception through April 30, 2010, was waived by USCF and will not be recouped from US12NG.
Ongoing Registration Fees and Other Offering Expenses
US12NG pays all costs and expenses associated with the ongoing registration of its units subsequent to the initial offering. These costs include registration or other fees paid to regulatory agencies in connection with the offer and sale of units, and all legal, accounting, printing and other expenses associated with such offer and sale. For the six months ended June 30, 2011 and 2010, US12NG did not incur any registration fees or other offering expenses.
Directors Fees and Expenses
US12NG is responsible for paying its portion of the directors and officers liability insurance of all affiliated funds for which USCF serves as general partner or sponsor (all affiliated funds including USCI) and the fees and expenses of the independent directors who also serve as audit committee members of those affiliated USCF funds organized as limited partnerships (all affiliated funds, excluding USCI). Effective as of April 1, 2010, US12NG became responsible for paying its portion of any payments that may become due to the independent directors pursuant to the deferred compensation agreements entered into between the independent directors, USCF and each of the affiliated funds, except USCI. US12NG shares all director fees and expenses, including any that may become due pursuant to the deferred compensation agreements, with all the affiliated funds except USCI, based on the relative assets of each fund, computed on a daily basis. These fees and expenses for the affiliated funds, except USCI, as described above, for the year ending December 31, 2011, are estimated to be a total of $540,000.
Licensing Fees
As discussed in Note 4 below, US12NG entered into a licensing agreement with the NYMEX on December 4, 2007. Pursuant to the agreement, US12NG and the affiliated funds managed by USCF, other than USBO and USCI, pay a licensing fee that is equal to 0.04% for the first $1,000,000,000 of combined assets of the funds and 0.02% for combined assets above $1,000,000,000. During the six months ended June 30, 2011 and 2010, US12NG incurred $4,211 and $4,158, respectively, under this arrangement.
Investor Tax Reporting Cost
The fees and expenses associated with US12NGs audit expenses and tax accounting and reporting requirements, with the exception of certain initial implementation service fees and base service fees, which were borne by USCF, are paid by US12NG. These costs are estimated to be $145,000 for the year ending December 31, 2011.
Other Expenses and Fees and Expense Waivers
In addition to the fees described above, US12NG pays all brokerage fees and other expenses in connection with the operation of US12NG, excluding costs and expenses paid by USCF as outlined in Note 4 below. USCF, though under no obligation to do so, agreed to pay certain costs for tax reporting and audit expenses normally borne by US12NG to the extent that such expenses exceed 0.15% (15 basis points) of US12NGs NAV, on an annualized basis, through at least December 31, 2011. USCF has no obligation to continue such payment into subsequent periods.
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NOTE 4 - CONTRACTS AND AGREEMENTS
US12NG is party to a marketing agent agreement, dated as of October 30, 2009, as amended from time to time, with the Marketing Agent and USCF, whereby the Marketing Agent provides certain marketing services for US12NG as outlined in the agreement. The fee of the Marketing Agent, which is borne by USCF, is equal to 0.06% on US12NGs assets up to $3 billion and 0.04% on US12NGs assets in excess of $3 billion.
The above fee does not include the following expenses, which are also borne by USCF: the cost of placing advertisements in various periodicals; web construction and development; or the printing and production of various marketing materials.
US12NG is also party to a custodian agreement, dated November 3, 2009, as amended from time to time, with Brown Brothers Harriman & Co. (BBH&Co.) and USCF, whereby BBH&Co. holds investments on behalf of US12NG. USCF pays the fees of the custodian, which are determined by the parties from time to time. In addition, US12NG is party to an administrative agency agreement, dated November 3, 2009, as amended from time to time, with USCF and BBH&Co., whereby BBH&Co. acts as the administrative agent, transfer agent and registrar for US12NG. USCF also pays the fees of BBH&Co. for its services under such agreement and such fees are determined by the parties from time to time.
Currently, USCF pays BBH&Co. for its services, in the foregoing capacities, a minimum amount of $75,000 annually for its custody, fund accounting and fund administration services rendered to US12NG and each of the affiliated funds managed by USCF, as well as a $20,000 annual fee for its transfer agency services. In addition, USCF pays BBH&Co. an asset-based charge of (a) 0.06% for the first $500 million of US12NGs, USOFs, USNGs, US12OFs, UGAs, USHOs, USSOs, USBOs and USCIs combined net assets, (b) 0.0465% for US12NGs, USOFs, USNGs, US12OFs, UGAs, USHOs, USSOs, USBOs and USCIs combined net assets greater than $500 million but less than $1 billion, and (c) 0.035% once US12NGs, USOFs, USNGs, US12OFs, UGAs, USHOs, USSOs, USBOs and USCIs combined net assets exceed $1 billion. The annual minimum amount will not apply if the asset-based charge for all accounts in the aggregate exceeds $75,000. USCF also pays transaction fees ranging from $7 to $15 per transaction.
US12NG has entered into a brokerage agreement with UBS Securities LLC (UBS Securities). The agreement requires UBS Securities to provide services to US12NG in connection with the purchase and sale of Futures Contracts and Other Natural Gas-Related Investments that may be purchased and sold by or through UBS Securities for US12NGs account. In accordance with the agreement, UBS Securities charges US12NG commissions of approximately $7 to $15 per round-turn trade, including applicable exchange and NFA fees for Futures Contracts and options on Futures Contracts.
On December 4, 2007, US12NG and the NYMEX entered into a licensing agreement whereby US12NG was granted a non-exclusive license to use certain of the NYMEXs settlement prices and service marks. Under the licensing agreement, US12NG and the affiliated funds managed by USCF, other than USBO and USCI, pay the NYMEX an asset-based fee for the license, the terms of which are described in Note 3.
US12NG expressly disclaims any association with the NYMEX or endorsement of US12NG by the NYMEX and acknowledges that NYMEX and New York Mercantile Exchange are registered trademarks of the NYMEX.
NOTE 5 - FINANCIAL INSTRUMENTS, OFF-BALANCE SHEET RISKS AND CONTINGENCIES
US12NG engages in the trading of futures contracts, options on futures contracts and cleared swaps (collectively, derivatives). US12NG is exposed to both market risk, which is the risk arising from changes in the market value of the contracts, and credit risk, which is the risk of failure by another party to perform according to the terms of a contract.
US12NG may enter into futures contracts, options on futures contracts and cleared swaps to gain exposure to changes in the value of an underlying commodity. A futures contract obligates the seller to deliver (and the purchaser to accept) the future delivery of a specified quantity and type of a commodity at a specified time and place. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The contractual obligations of a buyer or seller may generally be satisfied by taking or making physical delivery of the underlying commodity or by making an offsetting sale or purchase of an identical futures contract on the same or linked exchange before the designated date of delivery.
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The purchase and sale of futures contracts, options on futures contracts and cleared swaps require margin deposits with a futures commission merchant. Additional deposits may be necessary for any loss on contract value. The Commodity Exchange Act requires a futures commission merchant to segregate all customer transactions and assets from the futures commission merchants proprietary activities.
Futures contracts and cleared swaps involve, to varying degrees, elements of market risk (specifically commodity price risk) and exposure to loss in excess of the amount of variation margin. The face or contract amounts reflect the extent of the total exposure US12NG has in the particular classes of instruments. Additional risks associated with the use of futures contracts are an imperfect correlation between movements in the price of the futures contracts and the market value of the underlying securities and the possibility of an illiquid market for a futures contract.
Through June 30, 2011, all of the futures contracts held by US12NG were exchange-traded futures contracts. The liquidity and credit risks associated with exchange-traded contracts and cleared swaps are generally perceived to be less than those associated with over-the-counter transactions since, in over-the-counter transactions, a party must rely solely on the credit of its respective individual counterparties. As of June 30, 2011, US12NG has not entered into any cleared swaps or over-the-counter transactions. Over-the-counter transactions subject US12NG to the credit risk associated with counterparty non-performance. The credit risk from counterparty non-performance associated with such instruments is the net unrealized gain, if any, on the transaction. US12NG has credit risk under its futures contracts since the sole counterparty to all domestic and foreign futures contracts is the clearinghouse for the exchange on which the relevant contracts are traded. However, as compared to its over-the-counter transactions, it may more easily realize value by reselling its futures contracts. In addition, US12NG bears the risk of financial failure by the clearing broker.
US12NGs cash and other property, such as U.S. Treasuries, deposited with a futures commission merchant are considered commingled with all other customer funds, subject to the futures commission merchants segregation requirements. In the event of a futures commission merchants insolvency, recovery may be limited to a pro rata share of segregated funds available. It is possible that the recovered amount could be less than the total of cash and other property deposited. The insolvency of a futures commission merchant could result in the complete loss of US12NGs assets posted with that futures commission merchant; however, the vast majority of US12NGs assets are held in U.S. Treasuries, cash and/or cash equivalents with US12NGs custodian and would not be impacted by the insolvency of a futures commission merchant. Also, the failure or insolvency of US12NGs custodian could result in a substantial loss of US12NGs assets.
USCF invests a portion of US12NGs cash in money market funds that seek to maintain a stable net asset value. US12NG is exposed to any risk of loss associated with an investment in these money market funds. As of June 30, 2011 and December 31, 2010, US12NG had deposits in domestic and foreign financial institutions, including cash investments in money market funds, in the amounts of $37,344,848 and $37,279,967, respectively. This amount is subject to loss should these institutions cease operations.
For derivatives, risks arise from changes in the market value of the contracts. Theoretically, US12NG is exposed to market risk equal to the value of futures contracts purchased and unlimited liability on such contracts sold short. As both a buyer and a seller of options, US12NG pays or receives a premium at the outset and then bears the risk of unfavorable changes in the price of the contract underlying the option.
US12NGs policy is to continuously monitor its exposure to market and counterparty risk through the use of a variety of financial, position and credit exposure reporting controls and procedures. In addition, US12NG has a policy of requiring review of the credit standing of each broker or counterparty with which it conducts business.
The financial instruments held by US12NG are reported in its condensed statement of financial condition at market or fair value, or at carrying amounts that approximate fair value, because of their highly liquid nature and short-term maturity.
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NOTE 6 - FINANCIAL HIGHLIGHTS
The following table presents per unit performance data and other supplemental financial data for the six months ended June 30, 2011 and 2010 for the unitholders. This information has been derived from information presented in the condensed financial statements.
For the six
months ended June 30, 2011 (Unaudited) |
For the six
months ended June 30, 2010 (Unaudited) |
|||||||
Per Unit Operating Performance: |
| |||||||
Net asset value, beginning of period |
$ | 35.02 | $ | 53.77 | ||||
Total loss |
(2.29 | ) | (11.22 | ) | ||||
Total expenses |
(0.16 | ) | (0.19 | ) | ||||
|
|
|
|
|||||
Net decrease in net asset value |
(2.45 | ) | (11.41 | ) | ||||
|
|
|
|
|||||
Net asset value, end of period |
$ | 32.57 | $ | 42.36 | ||||
|
|
|
|
|||||
Total Return |
(7.00 | )% | (21.22 | )% | ||||
|
|
|
|
|||||
Ratios to Average Net Assets |
| |||||||
Total loss |
(6.81 | )% | (21.19 | )% | ||||
|
|
|
|
|||||
Management fees* |
0.75 | % | 0.65 | % | ||||
|
|
|
|
|||||
Total expenses excluding management fees* |
0.64 | % | 1.16 | % | ||||
|
|
|
|
|||||
Expenses waived* |
(0.43 | )% | (0.96 | )% | ||||
|
|
|
|
|||||
Net expenses excluding management fees* |
0.21 | % | 0.20 | % | ||||
|
|
|
|
|||||
Net loss |
(7.28 | )% | (21.61 | )% | ||||
|
|
|
|
* | Annualized |
Total returns are calculated based on the change in value during the period. An individual unitholders total return and ratio may vary from the above total returns and ratios based on the timing of contributions to and withdrawals from US12NG.
NOTE 7 - FAIR VALUE OF FINANCIAL INSTRUMENTS
US12NG values its investments in accordance with Accounting Standards Codification 820 - Fair Value Measurements and Disclosures (ASC 820). ASC 820 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. The changes to past practice resulting from the application of ASC 820 relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurement. ASC 820 establishes a fair value hierarchy that distinguishes between: (1) market participant assumptions developed based on market data obtained from sources independent of US12NG (observable inputs) and (2) US12NGs own assumptions about market participant assumptions developed based on the best information available under the circumstances (unobservable inputs). The three levels defined by the ASC 820 hierarchy are as follows:
Level I - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
Level II - Inputs other than quoted prices included within Level I that are observable for the asset or liability, either directly or indirectly. Level II assets include the following: quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs).
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Level III - Unobservable pricing input at the measurement date for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available.
In some instances, the inputs used to measure fair value might fall within different levels of the fair value hierarchy. The level in the fair value hierarchy within which the fair value measurement in its entirety falls shall be determined based on the lowest input level that is significant to the fair value measurement in its entirety.
The following table summarizes the valuation of US12NGs securities at December 31, 2010 using the fair value hierarchy:
At December 31, 2010 | Total | Level I | Level II | Level III | ||||||||||||
Short-Term Investments |
$ | 28,013,635 | $ | 28,013,635 | $ | | $ | | ||||||||
Exchange-Traded Futures Contracts |
||||||||||||||||
United States Contracts |
(2,175,060 | ) | (2,175,060 | ) | | |
During the year ended December 31, 2010, there were no significant transfers between Level I and Level II.
The following table summarizes the valuation of US12NGs securities at June 30, 2011 using the fair value hierarchy:
At June 30, 2011 | Total | Level I | Level II | Level III | ||||||||||||
Short-Term Investments |
$ | 32,017,537 | $ | 32,017,537 | $ | | $ | | ||||||||
Exchange-Traded Futures Contracts |
||||||||||||||||
United States Contracts |
(1,458,490 | ) | (1,458,490 | ) | | |
During the six months ended June 30, 2011, there were no significant transfers between Level I and Level II.
US12NG has adopted the provisions of Accounting Standards Codification 815 - Derivatives and Hedging, which require presentation of qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts and gains and losses on derivatives.
Fair Value of Derivative Instruments
Derivatives not Accounted for as Hedging Instruments |
Condensed
Statement of Financial Condition Location |
Fair Value At June 30, 2011 |
Fair Value At December 31, 2010 |
|||||||
Futures - Commodity Contracts |
Assets | $ | (1,458,490 | ) | $ | (2,175,060 | ) |
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The Effect of Derivative Instruments on the Condensed Statements of Operations
For the six months ended June 30, 2011 |
For the six months ended June 30, 2010 |
|||||||||||||||||
Derivatives for as Hedging Instruments |
Location of Gain or (Loss) on Derivatives Recognized in Income |
Realized Gain or (Loss) on Derivatives Recognized in Income |
Change in Unrealized Gain or (Loss) Recognized in Income |
Realized Gain or (Loss) on Derivatives Recognized in Income |
Change in Unrealized Gain or (Loss) Recognized in Income |
|||||||||||||
Futures - Commodity |
Realized loss on closed positions |
$ | (3,068,370 | ) | $ | (2,772,650 | ) | |||||||||||
Change in unrealized gain (loss) on open positions |
$ | 716,570 | $ | (4,783,520 | ) |
NOTE 8 - RECENT ACCOUNTING PRONOUNCEMENTS
In May 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. ASU No. 2011-04 clarifies existing requirements for measuring fair value and for disclosure about fair value measurements in converged guidance of the FASB and the International Accounting Standards Board. The amendments are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2011. Early application by public entities is not permitted. Nonpublic entities may apply the amendments early, but no earlier than for interim periods beginning after December 15, 2011. The implementation of ASU No. 2011-04 is not expected to have a material impact on US12NGs financial statement disclosures.
In January 2010, FASB issued ASU No. 2010-06 Improving Disclosures about Fair Value Measurements. ASU No. 2010-06 clarifies existing disclosure and requires additional disclosures regarding fair value measurements. Effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years, entities will need to disclose information about purchases, sales, issuances and settlements of Level 3 securities on a gross basis, rather than as a net number as currently required. The implementation of ASU No. 2010-06 is not expected to have a material impact on US12NGs financial statement disclosures.
NOTE 9 - SUBSEQUENT EVENTS
US12NG has performed an evaluation of subsequent events through the date the financial statements were issued. This evaluation did not result in any subsequent events that necessitated disclosures and/or adjustments.
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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion should be read in conjunction with the condensed financial statements and the notes thereto of the United States 12 Month Natural Gas Fund, LP (US12NG) included elsewhere in this quarterly report on Form 10-Q.
Forward-Looking Information
This quarterly report on Form 10-Q, including this Managements Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding the plans and objectives of management for future operations. This information may involve known and unknown risks, uncertainties and other factors that may cause US12NGs actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by any forward-looking statements. Forward-looking statements, which involve assumptions and describe US12NGs future plans, strategies and expectations, are generally identifiable by use of the words may, will, should, expect, anticipate, estimate, believe, intend or project, the negative of these words, other variations on these words or comparable terminology. These forward-looking statements are based on assumptions that may be incorrect, and US12NG cannot assure investors that the projections included in these forward-looking statements will come to pass. US12NGs actual results could differ materially from those expressed or implied by the forward-looking statements as a result of various factors.
US12NG has based the forward-looking statements included in this quarterly report on Form 10-Q on information available to it on the date of this quarterly report on Form 10-Q, and US12NG assumes no obligation to update any such forward-looking statements. Although US12NG undertakes no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, investors are advised to consult any additional disclosures that US12NG may make directly to them or through reports that US12NG in the future files with the U.S. Securities and Exchange Commission (the SEC), including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.
Introduction
US12NG, a Delaware limited partnership, is a commodity pool that issues units that may be purchased and sold on the NYSE Arca, Inc. (the NYSE Arca). The investment objective of US12NG is for the daily changes in percentage terms of its units net asset value (NAV) to reflect the daily changes in percentage terms of the spot price of natural gas delivered at the Henry Hub, Louisiana, as measured by the changes in the average of the prices of 12 futures contracts on natural gas traded on the New York Mercantile Exchange (the NYMEX), consisting of the near month contract to expire and the contracts for the following 11 months, for a total of 12 consecutive months contracts, except when the near month contract is within two weeks of expiration, in which case it will be measured by the futures contract that is the next month contract to expire and the contracts for the following 11 consecutive months, less US12NGs expenses. When calculating the daily movement of the average price of the 12 contracts, each contract month is equally weighted. It is not the intent of US12NG to be operated in a fashion such that the NAV will equal, in dollar terms, the spot price of natural gas or any particular futures contract based on natural gas. The general partner of US12NG, the United States Commodity Funds LLC (USCF), believes that it is not practical to manage the portfolio to achieve such an investment goal when investing in Futures Contracts (as defined below) and Other Natural Gas-Related Investments (as defined below).
US12NG invests in futures contracts for natural gas, crude oil, heating oil, gasoline and other petroleum-based fuels that are traded on the NYMEX, ICE Futures or other U.S. and foreign exchanges (collectively, Futures Contracts) and other natural gas-related investments such as cash-settled options on Futures Contracts, forward contracts for natural gas, cleared swap contracts and over-the-counter transactions that are based on the price of natural gas, crude oil and other petroleum-based fuels, Futures Contracts and indices based on the foregoing (collectively, Other Natural Gas-Related Investments). For convenience and unless otherwise specified, Futures Contracts and Other Natural Gas-Related Investments collectively are referred to as Natural Gas Interests in this quarterly report on Form 10-Q.
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US12NG seeks to achieve its investment objective by investing in a combination of natural gas Futures Contracts and Other Natural Gas-Related Investments such that changes in its NAV, measured in percentage terms, will closely track the changes in the average of the prices of the Benchmark Futures Contracts, also measured in percentage terms. USCF believes the daily changes in the average of the prices of the Benchmark Futures Contracts have historically exhibited a close correlation with the daily changes in the spot price of natural gas. It is not the intent of US12NG to be operated in a fashion such that the NAV will equal, in dollar terms, the spot price of natural gas or any particular futures contract based on natural gas. USCF believes that it is not practical to manage the portfolio to achieve such an investment goal when investing in listed natural gas Futures Contracts and Other Natural Gas-Related Investments.
On any valuation day, the Benchmark Futures Contracts are the near month futures contract for natural gas traded on the NYMEX and the contracts for the following 11 months for a total of 12 consecutive months contracts unless the near month contract is within two weeks of expiration, in which case the Benchmark Futures Contracts are the next month contract for natural gas traded on the NYMEX and the contracts for the following 11 consecutive months. Near month contract means the next contract traded on the NYMEX due to expire. Next month contract means the first contract traded on the NYMEX due to expire after the near month contract.
The regulation of commodity interests in the United States is subject to ongoing modification by governmental and judicial action. On July 21, 2010, a broad financial regulatory reform bill, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), was signed into law.
All of the Dodd-Frank Acts provisions will have become effective by the date of this quarterly report on Form 10-Q. However, new rules implementing, and in many cases, interpreting and clarifying, the Dodd-Frank Acts new requirements have not been finalized. Therefore, US12NG will necessarily operate in a period of regulatory uncertainty until new regulations have been finalized. Some specific examples of how the new Dodd-Frank Act provisions and rules adopted thereunder could impact US12NG are discussed below.
Provisions in the Dodd-Frank Act include the requirement that position limits be established on a wide range of commodity interests including energy-based and other commodity futures contracts, certain cleared commodity swaps and certain over-the-counter commodity contracts; new registration, recordkeeping, capital and margin requirements for swap dealers and major swap participants as determined by the new law and applicable regulations; and the forced use of clearinghouse mechanisms for most swap transactions that are currently entered into in the over-the-counter market. The new law and the rules thereunder may negatively impact US12NGs ability to meet its investment objective either through limits or requirements imposed on it or upon its counterparties. Further, increased regulation of, and the imposition of additional costs on, swap transactions under the new legislation and implementing regulations could cause a reduction in the swap market and the overall derivatives markets, which could restrict liquidity and adversely affect US12NG. In particular, new position limits imposed on US12NG or its counterparties may impact US12NGs ability to invest in a manner that most efficiently meets its investment objective, and new requirements, including capital and mandatory clearing, may increase the cost of US12NGs investments and doing business, which could adversely impact the ability of US12NG to achieve its investment objective.
On January 13, 2011, the U.S. Commodity Futures Trading Commission (the CFTC) proposed new rules, which if implemented in their proposed form, would establish position limits and limit formulas for certain physical commodity futures, including Futures Contracts and options on Futures Contracts executed pursuant to the rules of designated contract markets (i.e., certain regulated exchanges) and commodity swaps that are economically equivalent to such futures and options contracts. The CFTC has also proposed aggregate position limits that would apply across different trading venues to contracts based on the same underlying commodity. At this time, it is unknown precisely when such position limits would take effect. It is also unclear when the CFTCs proposed rule regarding position limits for futures contracts held during the last few days of trading in the near month contract to expire, which, under such proposed rule are substantially similar to the position limits currently set by the exchanges, will take effect.
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On April 12, 2011, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Farm Credit System and the Federal Housing Finance Agency (collectively, the Prudential Regulators) and the CFTC issued proposed rules establishing minimum initial and variation margin collection requirements for certain swap dealers and major swap participants (collectively, Covered Swap Entities), which if adopted, would require Covered Swap Entities to collect minimum initial and variation margin amounts from swap counterparties. The public comment period for these rules was extended on June 23, 2011. The Prudential Regulators proposed rules would apply to those Covered Swap Entities that are regulated by the Prudential Regulators and the CFTCs proposed rules would apply to Covered Swap Entities that are not regulated by the Prudential Regulators.
The amount of initial and variation margin that Covered Swap Entities would be required to collect under the proposed rules varies based on whether their counterparty to a particular swap is (1) a Covered Swap Entity, (2) a high-risk financial entity end-user, (3) a low-risk financial entity end-user (e.g., financial entities subject to capital requirements imposed by bank or insurance regulators, that predominantly use swaps to hedge and that do not have significant swap exposure) or (4) a non-financial end-user. With certain exceptions not applicable to US12NG and the affiliated funds managed by USCF, Covered Swap Entities would not be required to post initial or variation margin to any of their counterparties except for other Covered Swap Entities.
Covered Swap Entities and all financial entity end-users would be required to post initial margin and variation margin when they enter into swaps with Covered Swap Entities. Margin posted by low-risk financial entity end-users could be subject to thresholds under the proposed rules. As commodity pools, US12NG and the affiliated funds managed by USCF would be high-risk financial entity end-users and would therefore have to post margin without thresholds.
The CFTC and the SEC have proposed joint rules defining swaps and security-based swaps, which would provide additional clarity regarding which transactions will be regulated as such under the Dodd-Frank Act and, more specifically, whether and how new CFTC and SEC rules will apply to US12NG. The CFTC has now issued proposed versions of all of the rules it is required to promulgate under the Dodd-Frank Act but, with one exception not applicable to US12NG and the affiliated funds managed by USCF, the CFTC has not promulgated any final rules or indicated when such final rules would take effect. On July 14, 2011, the CFTC issued an order providing temporary relief from certain swaps-related provisions of Title VII that would have automatically taken effect on July 16, 2011. The final order granted temporary exemptive relief that, by its terms, expires upon the earlier of the effective date of the required final rulemaking or December 31, 2011. The effect of the future regulatory change on US12NG is impossible to predict, but it could be substantial and adverse.
USCF, which is registered as a commodity pool operator (CPO) with the CFTC, is authorized by the Amended and Restated Agreement of Limited Partnership of US12NG (the LP Agreement) to manage US12NG. USCF is authorized by US12NG in its sole judgment to employ and establish the terms of employment for, and termination of, commodity trading advisors or futures commission merchants.
Price Movements
Natural gas futures prices were volatile during the six months ended June 30, 2011. The average price of the Benchmark Futures Contracts started the period at $4.64. It hit a peak on June 8, 2011 of $5.059 and fell during the course of the period. The average low price of the period was on March 3, 2011, when the average price of the Benchmark Futures Contracts was $4.223. The average price of the Benchmark Futures Contracts on June 30, 2011 was $4.65, for a return of approximately 0.30% over the period. US12NGs NAV initially rose during the period from a starting level of $35.02 per unit to a high on January 21, 2011 of $36.79 per unit. US12NGs NAV reached its low for the period on March 3, 2011 at $30.92 per unit. The NAV on June 30, 2011 was $32.57, down approximately 7.00% over the period. The Benchmark Futures Contract prices listed above began with the February 2011-January 2012 contracts and ended with the August 2011-July 2012 contracts. The return of approximately 0.30% on the average price of the Benchmark Futures Contracts listed above is a hypothetical return only and could not actually be achieved by an investor holding Futures Contracts. An investment in natural gas Futures Contracts would need to be rolled forward during the time period described in order to achieve such a result. Furthermore, the change in the nominal price of these differing natural gas Futures Contracts, measured from the start of the period to the end of the period, does not represent the actual benchmark results that US12NG seeks to track, which are more fully described below in the section titled Tracking US12NGs Benchmark.
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During the six months ended June 30, 2011, the natural gas futures market was primarily in a state of contango, with the exception of a brief period in early January 2011, meaning that the price of the near month natural gas Futures Contract was typically lower than the price of the next month natural gas Futures Contract, or contracts further away from expiration. A contango market is one in which the price of the near month natural gas Futures Contract is less than the price of the next month natural gas Futures Contract, or contracts further away from expiration. For a discussion of the impact of backwardation and contango on total returns, see Term Structure of Natural Gas Futures Prices and the Impact on Total Returns below.
Valuation of Futures Contracts and the Computation of the NAV
The NAV of US12NGs units is calculated once each NYSE Arca trading day. The NAV for a particular trading day is released after 4:00 p.m. New York time. Trading during the core trading session on the NYSE Arca typically closes at 4:00 p.m. New York time. US12NGs administrator uses the NYMEX closing price (determined at the earlier of the close of the NYMEX or 2:30 p.m. New York time) for the contracts held on the NYMEX, but calculates or determines the value of all other US12NG investments, including cleared swaps, or other futures contracts, as of the earlier of the close of the NYSE Arca or 4:00 p.m. New York time.
Results of Operations and the Natural Gas Market
Results of Operations. On November 18, 2009, US12NG listed its units on the NYSE Arca under the ticker symbol UNL. On that day, US12NG established its initial offering price at $50.00 per unit and issued 200,000 units to the initial authorized purchaser, Merrill Lynch Professional Clearing Corp., in exchange for $10,001,000 in cash.
Since its initial offering of 30,000,000 units, US12NG has not registered any subsequent offerings of its units. As of June 30, 2011, US12NG had issued 1,900,000 units, 1,100,000 of which were outstanding. As of June 30, 2011, there were 28,100,000 units registered but not yet issued.
More units may have been issued by US12NG than are outstanding due to the redemption of units. Unlike funds that are registered under the Investment Company Act of 1940, as amended, units that have been redeemed by US12NG cannot be resold by US12NG. As a result, US12NG contemplates that additional offerings of its units will be registered with the SEC in the future in anticipation of additional issuances and redemptions.
For the Six Months Ended June 30, 2011 Compared to the Six Months Ended June 30, 2010
As of June 30, 2011, the total unrealized loss on natural gas Futures Contracts owned or held on that day was $1,458,490 and US12NG established cash deposits, including cash investments in money market funds that were equal to $37,344,848. US12NG held 87.25% of its cash assets in overnight deposits and money market funds at its custodian bank, while 12.75% of the cash balance was held as margin deposits for the Futures Contracts purchased. The ending per unit NAV on June 30, 2011 was $32.57.
By comparison, as of June 30, 2010, the total unrealized loss on natural gas Futures Contracts owned or held on that day was $3,120,850, and US12NG established cash deposits, including cash investments in money market funds, that were equal to $32,814,479. US12NG held 80.90% of its cash assets in overnight deposits and money market funds at its custodian bank, while 19.10% of the cash balance was held as margin deposits for the Futures Contracts purchased. The increase in cash assets in overnight deposits and money market funds for June 30, 2011 as compared to June 30, 2010 was the result of US12NGs larger size in the prior period as measured by total net assets. The ending per unit NAV on June 30, 2010 was $42.36. The decrease in the per unit NAV from June 30, 2011 as compared to June 30, 2010 was primarily a result of sharply lower prices for natural gas and the related decline in the value of the Futures Contracts that US12NG had invested in between the period ended June 30, 2010 and the period ended June 30, 2011.
Portfolio Expenses. US12NGs expenses consist of investment management fees, brokerage fees and commissions, certain offering costs, licensing fees, the fees and expenses of the independent directors of USCF and expenses relating to tax accounting and reporting requirements. The management fee that US12NG pays to USCF is calculated as a percentage of the total net assets of US12NG. US12NG pays USCF a management fee of 0.75% of NAV on its average net assets. The fee is accrued daily and paid monthly. Since inception through April 30, 2010, USCF was charging US12NG a management fee at a reduced rate of 0.60% per annum of average daily net assets. Effective May 1, 2010, USCF resumed charging its standard rate of 0.75% per annum of average daily net assets. The difference of 0.15% per annum of average daily net assets since inception through April 30, 2010 was waived by USCF and will not be recouped from US12NG.
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During the six months ended June 30, 2011, the daily average total net assets of US12NG were $34,436,602. The management fee incurred by US12NG during the period amounted to $128,076. Management fees as a percentage of total net assets averaged 0.75% over the course of this six month period. By comparison, during the six months ended June 30, 2010, the daily average total net assets of US12NG were $35,619,620. The management fee paid by US12NG during the period amounted to $114,795. Management fees as a percentage of total net assets averaged 0.65% over the course of this six month period. US12NGs management fees as a percentage of total net assets were higher for the six months ended June 30, 2011, as compared to the six months ended June 30, 2010, due to the fact that USCF resumed charging its standard rate effective May 1, 2010, as detailed in the paragraph above.
In addition to the management fee, US12NG pays all brokerage fees and other expenses, including certain tax reporting costs, licensing fees for the use of intellectual property, ongoing registration or other fees paid to the SEC, the Financial Industry Regulatory Authority (FINRA) and any other regulatory agency in connection with offers and sales of its units subsequent to the initial offering and all legal, accounting, printing and other expenses associated therewith. The total of these fees and expenses for the six months ended June 30, 2011 was $109,640, as compared to $204,580 for the six months ended June 30, 2010. The decrease in expenses for the six months ended June 30, 2011 as compared to the six months ended June 30, 2010 was primarily due to decreased tax reporting, audit, licensing, directors, and other fees during the six months ended June 30, 2011. For the six months ended June 30, 2011 and 2010, US12NG did not incur any ongoing registration fees or other expenses relating to the registration and offering of additional units. During the six months ended June 30, 2011 and 2010, an expense waiver was in effect which offset certain of the expenses incurred by US12NG. The total amount of the expense waiver was $73,573 for the six months ended June 30, 2011 and $169,020 for the six months ended June 30, 2010. For the six months ended June 30, 2011 and 2010, the expenses of US12NG, including management fees, commissions, and all other expenses, before allowance for the expense waiver, totaled $237,716 and $319,375, respectively, and after allowance for the expense waiver, totaled $164,143 and $150,355, respectively.
US12NG is responsible for paying its portion of the directors and officers liability insurance of all affiliated funds for which USCF serves as general partner and sponsor (all affiliated funds including the United States Commodity Index Fund (USCI)) and the fees and expenses of the independent directors who also serve as audit committee members of those affiliated USCF funds organized as limited partnerships (all affiliated funds, excluding USCI). Affiliated funds of US12NG include the United States Oil Fund, LP (USOF), the United States Natural Gas Fund, LP (USNG), the United States 12 Month Oil Fund, LP (US12OF), the United States Gasoline Fund, LP (UGA), the United States Heating Oil Fund, LP (USHO), the United States Short Oil Fund, LP (USSO), the United States Brent Oil Fund, LP (USBO) and USCI. US12NG shares the fees and expenses with each affiliated fund, as described above, based on the relative assets of each fund computed on a daily basis. These fees and expenses for the year ending December 31, 2011 are estimated to be a total of $540,000 for all affiliated funds, except USCI. By comparison, for the year ended December 31, 2010, these fees and expenses amounted to a total of $1,107,140 for all affiliated funds, except USCI, and US12NGs portion of such fees and expenses was $7,571. Effective as of April 1, 2010, US12NG became responsible for paying its portion of any payments that may become due to the independent directors pursuant to the deferred compensation agreements entered into between the independent directors, USCF and the affiliated funds, except USCI.
US12NG also incurs commissions to brokers for the purchase and sale of Futures Contracts, Other Natural Gas-Related Investments or short-term obligations of the United States of two years or less (Treasuries). During the six months ended June 30, 2011, total commissions paid to brokers amounted to $4,378. By comparison, during the six months ended June 30, 2010, total commissions paid to brokers amounted to $6,213. The decrease in the total commissions paid to brokers for the six months ended June 30, 2011 as compared to the six months ended June 30, 2010 was primarily a function of decreased brokerage fees due to a lower number of futures contracts being held and traded due to a decrease in redemptions of units during the six months ended June 30, 2011. As an annualized percentage of total net assets, the figure for the six months ended June 30, 2011 represents approximately 0.02% of total net assets. By comparison, the figure for the six months ended June 30, 2010 represented approximately 0.04% of total net assets. However, there can be no assurance that commission costs and portfolio turnover will not cause commission expenses to rise in future quarters.
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US12NG did not incur transaction costs related to investments in Other Natural Gas-Related Investments, including over-the-counter swaps, during the six months ended June 30, 2011.
The fees and expenses associated with US12NGs audit expenses and tax accounting and reporting requirements, with the exception of certain initial implementation service fees and base service fees which were borne by USCF, are paid by US12NG. These costs are estimated to be $145,000 for the year ending December 31, 2011. USCF, though under no obligation to do so, agreed to pay certain costs for tax reporting and audit expenses normally borne by US12NG to the extent that such expenses exceed 0.15% (15 basis points) of US12NGs NAV, on an annualized basis, through at least December 31, 2011. USCF has no obligation to continue such payments into subsequent periods.
Dividend and Interest Income. US12NG seeks to invest its assets such that it holds Futures Contracts and Other Natural Gas-Related Investments in an amount equal to the total net assets of its portfolio. Typically, such investments do not require US12NG to pay the full amount of the contract value at the time of purchase, but rather require US12NG to post an amount as a margin deposit against the eventual settlement of the contract. As a result, US12NG retains an amount that is approximately equal to its total net assets, which US12NG invests in Treasuries, cash and/or cash equivalents. This includes both the amount on deposit with the futures commission merchant as margin, as well as unrestricted cash and cash equivalents held with US12NGs custodian bank. The Treasuries, cash and/or cash equivalents earn income that accrues on a daily basis. For the six months ended June 30, 2011, US12NG earned $3,308 in dividend and interest income on such cash and/or cash equivalents. Based on US12NGs average daily total net assets, this was equivalent to an annualized yield of 0.02%. US12NG did not purchase Treasuries during the six months ended June 30, 2011 and held only cash and/or cash equivalents during this time period. By comparison, for the six months ended June 30, 2010, US12NG earned $5,647 in dividend and interest income on such cash and/or cash equivalents. Based on US12NGs average daily total net assets, this was equivalent to an annualized yield of 0.03%. US12NG did not purchase Treasuries during the six months ended June 30, 2010 and held only cash and/or cash equivalents during this time period. Interest rates on short-term investments, including cash, cash equivalents and Treasuries, were lower during the six months ended June 30, 2011 compared to the same time period in 2010. As a result, the amount of income earned by US12NG as a percentage of total net assets was lower during the six months ended June 30, 2011 compared to the six months ended June 30, 2010.
For the Three Months Ended June 30, 2011 Compared to the Three Months Ended June 30, 2010
Portfolio Expenses. During the three months ended June 30, 2011, the daily average total net assets of US12NG were $37,343,592. The management fee incurred by US12NG during the period amounted to $69,828. Management fees as a percentage of total net assets averaged 0.75% over the course of this three month period. By comparison, during the three months ended June 30, 2010, the daily average total net assets of US12NG were $35,920,484. The management fee paid by US12NG during the period amounted to $62,548. Management fees as a percentage of total net assets averaged 0.70% over the course of this three month period. US12NGs management fees as a percentage of total net assets were higher for the three months ended June 30, 2011, as compared to the three months ended June 30, 2010, due to the fact that USCF resumed charging its standard rate effective May 1, 2010, as described above.
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In addition to the management fee, US12NG pays all brokerage fees and other expenses, including certain tax reporting costs, licensing fees for the use of intellectual property, ongoing registration or other fees paid to the SEC, FINRA and any other regulatory agency in connection with offers and sales of its units subsequent to the initial offering and all legal, accounting, printing and other expenses associated therewith. The total of these fees and expenses for the three months ended June 30, 2011 was $54,932, as compared to $48,383 for the three months ended June 30, 2010. The increase in expenses for the three months ended June 30, 2011 as compared to the three months ended June 30, 2010 was primarily due to the relative size of US12NG and activity that resulted from its increased size, including increased tax reporting, audit, licensing, directors, and other fees during the three months ended June 30, 2011. For the three months ended June 30, 2011 and 2010, US12NG did not incur any ongoing registration fees or other expenses relating to the registration and offering of additional units. During the three months ended June 30, 2011 and 2010, an expense waiver was in effect which offset certain of the expenses incurred by US12NG. The total amount of the expense waiver was $35,903 for the three months ended June 30, 2011 and $30,482 for the three months ended June 30, 2010. For the three months ended June 30, 2011 and 2010, the expenses of US12NG, including management fees, commissions, and all other expenses, before allowance for the expense waiver, totaled $124,760 and $110,931, respectively, and after allowance for the expense waiver, totaled $88,857 and $80,449, respectively.
US12NG is responsible for paying its portion of the directors and officers liability insurance of all affiliated funds for which USCF serves as general partner and sponsor (all affiliated funds including USCI) and the fees and expenses of the independent directors who also serve as audit committee members of those affiliated USCF funds organized as limited partnerships (all affiliated funds, excluding USCI). Affiliated funds of US12NG include USOF, USNG, US12OF, UGA, USHO, USSO, USBO and USCI. US12NG shares the fees and expenses with each affiliated fund, as described above, based on the relative assets of each fund computed on a daily basis. These fees and expenses for the year ending December 31, 2011 are estimated to be a total of $540,000 for all affiliated funds, except USCI. By comparison, for the year ended December 31, 2010, these fees and expenses amounted to a total of $1,107,140 for all affiliated funds, except USCI, and US12NGs portion of such fees and expenses was $7,571. Effective as of April 1, 2010, US12NG became responsible for paying its portion of any payments that may become due to the independent directors pursuant to the deferred compensation agreements entered into between the independent directors, USCF and the affiliated funds, except USCI.
US12NG also incurs commissions to brokers for the purchase and sale of Futures Contracts, Other Natural Gas-Related Investments or Treasuries. During the three months ended June 30, 2011, total commissions paid to brokers amounted to $1,712. By comparison, during the three months ended June 30, 2010, total commissions paid to brokers amounted to $4,193. The decrease in the total commissions paid to brokers for the three months ended June 30, 2011 as compared to the three months ended June 30, 2010 was primarily a function of decreased brokerage fees due to a lower number of futures contracts being held and traded due to a decrease in redemptions and creations of units during the three months ended June 30, 2011. As an annualized percentage of total net assets, the figure for the three months ended June 30, 2011 represents approximately 0.02% of total net assets. By comparison, the figure for the three months ended June 30, 2010 represented approximately 0.05% of total net assets. However, there can be no assurance that commission costs and portfolio turnover will not cause commission expenses to rise in future quarters.
US12NG did not incur transaction costs related to investments in Other Natural Gas-Related Investments, including over-the-counter swaps, during the three months ended June 30, 2011.
The fees and expenses associated with US12NGs audit expenses and tax accounting and reporting requirements, with the exception of certain initial implementation service fees and base service fees which were borne by USCF, are paid by US12NG. These costs are estimated to be $145,000 for the year ending December 31, 2011. USCF, though under no obligation to do so, agreed to pay certain costs for tax reporting and audit expenses normally borne by US12NG to the extent that such expenses exceed 0.15% (15 basis points) of US12NGs NAV, on an annualized basis, through at least December 31, 2011. USCF has no obligation to continue such payments into subsequent periods.
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Dividend and Interest Income. US12NG seeks to invest its assets such that it holds Futures Contracts and Other Natural Gas-Related Investments in an amount equal to the total net assets of its portfolio. Typically, such investments do not require US12NG to pay the full amount of the contract value at the time of purchase, but rather require US12NG to post an amount as a margin deposit against the eventual settlement of the contract. As a result, US12NG retains an amount that is approximately equal to its total net assets, which US12NG invests in Treasuries, cash and/or cash equivalents. This includes both the amount on deposit with the futures commission merchant as margin, as well as unrestricted cash and cash equivalents held with US12NGs custodian bank. The Treasuries, cash and/or cash equivalents earn income that accrues on a daily basis. For the three months ended June 30, 2011, US12NG earned $1,003 in dividend and interest income on such cash and/or cash equivalents. Based on US12NGs average daily total net assets, this was equivalent to an annualized yield of 0.01%. US12NG did not purchase Treasuries during the three months ended June 30, 2011 and held only cash and/or cash equivalents during this time period. By comparison, for the three months ended June 30, 2010, US12NG earned $3,765 in dividend and interest income on such cash and/or cash equivalents. Based on US12NGs average daily total net assets, this was equivalent to an annualized yield of 0.04%. US12NG did not purchase Treasuries during the three months ended June 30, 2010 and held only cash and/or cash equivalents during this time period. Interest rates on short-term investments, including cash, cash equivalents and Treasuries, were lower during the three months ended June 30, 2011 compared to the same time period in 2010. As a result, the amount of income earned by US12NG as a percentage of total net assets was lower during the three months ended June 30, 2011 compared to the three months ended June 30, 2010.
Tracking US12NGs Benchmark
USCF seeks to manage US12NGs portfolio such that changes in its average daily NAV, on a percentage basis, closely track the changes in the average of the daily prices of the Benchmark Futures Contracts, also on a percentage basis. Specifically, USCF seeks to manage the portfolio such that over any rolling period of 30 valuation days, the average daily change in US12NGs NAV is within a range of 90% to 110% (0.9 to 1.1) of the average daily change in the price of the Benchmark Futures Contracts. As an example, if the average daily movement of the average of the prices of the Benchmark Futures Contracts for a particular 30 valuation day time period was 0.5% per day, USCF would attempt to manage the portfolio such that the average daily movement of the NAV during that same time period fell between 0.45% and 0.55% (i.e., between 0.9 and 1.1 of the benchmarks results). US12NGs portfolio management goals do not include trying to make the nominal price of US12NGs NAV equal to the average of the nominal prices of the current Benchmark Futures Contracts or the spot price for natural gas. USCF believes that it is not practical to manage the portfolio to achieve such an investment goal when investing in listed natural gas Futures Contracts and Other Natural Gas-Related Investments.
For the 30 valuation days ended June 30, 2011, the simple average daily change in the average of the Benchmark Futures Contracts was 0.012%, while the simple average daily change in the NAV of US12NG over the same time period was 0.008%. The average daily difference was -0.004% (or -0.4 basis points, where 1 basis point equals 1/100 of 1%). As a percentage of the daily movement of the average price of the Benchmark Futures Contracts, the average error in daily tracking by the NAV was 0.644%, meaning that over this time period US12NGs tracking error was within the plus or minus 10% range established as its benchmark tracking goal. The first chart below shows the daily movement of US12NGs NAV versus the daily movement of the Benchmark Futures Contracts for the 30-valuation day period ended June 30, 2011. The second chart below shows the monthly total returns of US12NG as compared to the monthly value of the Benchmark Futures Contracts since inception.
Since the commencement of the offering of US12NG units to the public on November 18, 2009 to June 30, 2011, the simple average daily change in the average price of its Benchmark Futures Contracts was -0.084%, while the simple average daily change in the NAV of US12NG over the same time period was -0.088%. The average daily difference was -0.004% (or -0.4 basis points, where 1 basis point equals 1/100 of 1%). As a percentage of the daily movement of the average price of the Benchmark Futures Contracts, the average error in daily tracking by the NAV was -0.512%, meaning that over this time period US12NGs tracking error was within the plus or minus 10% range established as its benchmark tracking goal.
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* PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
* PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
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An alternative tracking measurement of the return performance of US12NG versus the return of its Benchmark Futures Contracts can be calculated by comparing the actual return of US12NG, measured by changes in its NAV, versus the expected changes in its NAV under the assumption that US12NGs returns had been exactly the same as the daily changes in its Benchmark Futures Contracts.
For the six months ended June 30, 2011, the actual total return of US12NG as measured by changes in its NAV was -7.00%. This is based on an initial NAV of $35.02 on December 31, 2010 and an ending NAV as of June 30, 2011 of $32.57. During this time period, US12NG made no distributions to its unitholders. However, if US12NGs daily changes in its NAV had instead exactly tracked the changes in the daily return of the Benchmark Futures Contracts, US12NG would have had an estimated NAV of $32.73 as of June 30, 2011, for a total return over the relevant time period of -6.59%. The difference between the actual NAV total return of US12NG of -7.00% and the expected total return based on the Benchmark Futures Contracts of -6.59% was an error over the time period of -0.46%, which is to say that US12NGs actual total return underperformed the benchmark result by that percentage. USCF believes that a portion of the difference between the actual return and the expected benchmark return can be attributed to the net impact of the expenses that US12NG pays, offset in part by the income that US12NG collects on its cash and cash equivalent holdings. During the six months ended June 30, 2011, US12NG received dividend and interest income of $3,308, which is equivalent to a weighted average income rate of 0.02% for such period. In addition, during the six months ended June 30, 2011, US12NG also collected $5,000 from its Authorized Purchasers for creating or redeeming baskets of units. This income also contributed to US12NGs actual return. However, if the total assets of US12NG continue to increase, USCF believes that the impact on total returns of these fees from creations and redemptions will diminish as a percentage of the total return. During the six months ended June 30, 2011, US12NG incurred total net expenses of $164,143. Income from dividends and interest and Authorized Purchaser collections net of expenses was $(155,835), which is equivalent to an annualized weighted average net income rate of -0.91% for the six months ended June 30, 2011.
By comparison, for the six months ended June 30, 2010, the actual total return of US12NG as measured by changes in its NAV was -21.22%. This was based on an initial NAV of $53.77 on December 31, 2009 and an ending NAV as of June 30, 2010 of $42.36. During this time period, US12NG made no distributions to its unitholders. However, if US12NGs daily changes in its NAV had instead exactly tracked the changes in the daily return of the Benchmark Futures Contracts, US12NG would have had an estimated NAV of $42.52 as of June 30, 2010, for a total return over the relevant time period of -20.92%. The difference between the actual NAV total return of US12NG of -21.22% and the expected total return based on the Benchmark Futures Contracts of -20.92% was an error over the time period of -0.30%, which is to say that US12NGs actual total return underperformed the benchmark result by that percentage. USCF believes that a portion of the difference between the actual return and the expected benchmark return can be attributed to the net impact of the expenses that US12NG paid, offset in part by the income that US12NG collected on its cash and cash equivalent holdings. During the six months ended June 30, 2010, US12NG received dividend and interest income of $5,647, which is equivalent to a weighted average income rate of 0.03% for such period. In addition, during the six months ended June 30, 2010, US12NG also collected $4,000 from its Authorized Purchasers for creating or redeeming baskets of units. This income also contributed to US12NGs actual return. During the six months ended June 30, 2010, US12NG incurred total net expenses of $150,355. Income from dividends and interest and Authorized Purchaser collections net of expenses was $(140,708), which is equivalent to an annualized weighted average net income rate of -0.80% for the six months ended June 30, 2010.
There are currently three factors that have impacted or are most likely to impact US12NGs ability to accurately track its Benchmark Futures Contracts.
First, US12NG may buy or sell its holdings in the then current Benchmark Futures Contracts at a price other than the closing settlement price of that contract on the day during which US12NG executes the trade. In that case, US12NG may pay a price that is higher, or lower, than that of the Benchmark Futures Contracts, which could cause the changes in the daily NAV of US12NG to either be too high or too low relative to the changes in the Benchmark Futures Contracts. During the six months ended June 30, 2011, USCF attempted to minimize the effect of these transactions by seeking to execute its purchase or sale of the Benchmark Futures Contracts at, or as close as possible to, the end of the day settlement price. However, it may not always be possible for US12NG to obtain the closing settlement price and there is no assurance that failure to obtain the closing settlement price in the future will not adversely impact US12NGs attempt to track the Benchmark Futures Contracts over time.
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Second, US12NG earns dividend and interest income on its cash and cash equivalents. US12NG is not required to distribute any portion of its income to its unitholders and did not make any distributions to unitholders during the six months ended June 30, 2011. Interest payments, and any other income, were retained within the portfolio and added to US12NGs NAV. When this income exceeds the level of US12NGs expenses for its management fee, brokerage commissions and other expenses (including ongoing registration fees, licensing fees and the fees and expenses of the independent directors of USCF), US12NG will realize a net yield that will tend to cause daily changes in the NAV of US12NG to track slightly higher than daily changes in the Benchmark Futures Contracts. During the six months ended June 30, 2011, US12NG earned, on an annualized basis, approximately 0.02% on its cash holdings. It also incurred cash expenses on an annualized basis of 0.75% for management fees, approximately 0.02% in brokerage commission costs related to the purchase and sale of futures contracts and 0.19% for other net expenses. The foregoing fees and expenses resulted in a net yield on an annualized basis of approximately -0.94% and affected US12NGs ability to track its benchmark. If short-term interest rates rise above the current levels, the level of deviation created by the yield would decrease. Conversely, if short-term interest rates were to decline, the amount of error created by the yield would increase. When short-term yields drop to a level lower than the combined expenses of the management fee and the brokerage commissions, then the tracking error becomes a negative number and would tend to cause the daily returns of the NAV to underperform the daily returns of the Benchmark Futures Contracts.
Third, US12NG may hold Other Natural Gas-Related Investments in its portfolio that may fail to closely track the Benchmark Futures Contracts total return movements. In that case, the error in tracking the changes in the average of the Benchmark Futures Contracts could result in daily changes in the NAV of US12NG that are either too high, or too low, relative to the daily changes in the average of the Benchmark Futures Contracts. During the six months ended June 30, 2011, US12NG did not hold Other Natural Gas-Related Investments. If US12NG increases in size, and due to its obligations to comply with regulatory limits, US12NG may invest in Other Natural Gas-Related Investments which may have the effect of increasing transaction related expenses and may result in increased tracking error.
Term Structure of Natural Gas Futures Prices and the Impact on Total Returns. Several factors determine the total return from investing in a futures contract position. One factor that impacts the total return that will result from investing in near month natural gas Futures Contracts and rolling those contracts forward each month is the price relationship between the current near month contract and the next month contract. For example, if the price of the near month contract is higher than the next month contract (a situation referred to as backwardation in the futures market), then absent any other change there is a tendency for the price of a next month contract to rise in value as it becomes the near month contract and approaches expiration. Conversely, if the price of a near month contract is lower than the next month contract (a situation referred to as contango in the futures market), then absent any other change there is a tendency for the price of a next month contract to decline in value as it becomes the near month contract and approaches expiration.
As an example, assume that the price of natural gas for immediate delivery (the spot price), was $7 per 10,000 million British thermal units (MMBtu), and the value of a position in the near month futures contract was also $7. Over time, the price of 10,000 MMBtu of natural gas will fluctuate based on a number of market factors, including demand for natural gas relative to its supply. The value of the near month contract will likewise fluctuate in reaction to a number of market factors. If investors seek to maintain their position in a near month contract and not take delivery of the natural gas, every month they must sell their current near month contract as it approaches expiration and invest in the next month contract.
If the futures market is in backwardation, e.g., when the expected price of natural gas in the future would be less, the investor would be buying a next month contract for a lower price than the current near month contract. Hypothetically, and assuming no other changes to either prevailing natural gas prices or the price relationship between the spot price, the near month contract and the next month contract (and ignoring the impact of commission costs and the income earned on Treasuries, cash and/or cash equivalents), the value of the next month contract would rise as it approaches expiration and becomes the new near month contract. In this example, the value of the $7 investment would tend to rise faster than the spot price of natural gas, or fall slower. As a result, it would be possible in this hypothetical example for the spot price of natural gas to have risen to $9 after some period of time, while the value of the investment in the futures contract would have risen to $10, assuming backwardation is large enough or enough time has elapsed. Similarly, the spot price of natural gas could have fallen to $5 while the value of an investment in the futures contract could have fallen to only $6. Over time, if backwardation remained constant, the difference would continue to increase.
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If the futures market is in contango, the investor would be buying a next month contract for a higher price than the current near month contract. Hypothetically, and assuming no other changes to either prevailing natural gas prices or the price relationship between the spot price, the near month contract and the next month contract (and ignoring the impact of commission costs and the income earned on cash and/or cash equivalents), the value of the next month contract would fall as it approaches expiration and becomes the new near month contract. In this example, it would mean that the value of the $7 investment would tend to rise slower than the spot price of natural gas, or fall faster. As a result, it would be possible in this hypothetical example for the spot price of natural gas to have risen to $9 after some period of time, while the value of the investment in the futures contract will have risen to only $8, assuming contango is large enough or enough time has elapsed. Similarly, the spot price of natural gas could have fallen to $6 while the value of an investment in the futures contract could have fallen to $5. Over time, if contango remained constant, the difference would continue to increase.
The chart below compares the price of the near month contract to the average price of the near 12-month contracts over the last 10 years (2001-2010) for natural gas. When the price of the near month contract is higher than the average price of the near 12-month contracts, the market would be described as being in backwardation. When the price of the near month contract is lower than the average price of the near 12-month contracts, the market would be described as being in contango. Although the prices of the near month contract and the average price of the near 12-month contracts do tend to move up or down together, it can be seen that at times the near month prices are clearly higher than the average price of the near 12-month contracts (backwardation), and other times they are below the average price of the near 12- month contracts (contango). In addition, investors can observe that natural gas prices, both front month and second month, often display a seasonal pattern in which the price of natural gas tends to rise in the early winter months and decline in the summer months. This mirrors the physical demand for natural gas, which typically peaks in the winter.
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* PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
An alternative way to view backwardation and contango data over time is to subtract the dollar price of the near month natural gas Futures Contract from the dollar price of the near 12 month natural gas Futures Contracts. If the resulting number is a positive number, then the near month price is higher than the average price of the near 12 months and the market could be described as being in backwardation. If the resulting number is a negative number, then the near month price is lower than the average price of the near 12 months and the market could be described as being in contango. The chart below shows the results from subtracting the average dollar price of the near 12-month contracts from the near month price for the 10 year period between 2001 and 2010. Investors will note that the natural gas market spent time in both backwardation and contango. Investors will further note that the markets display a seasonal pattern that corresponds to the seasonal demand patterns for natural gas above. That is, in many, but not all, cases the average price of the near 12-month contracts is higher than the near month during the approach to the winter months as the price of natural gas for delivery in those winter months rises on expectations of demand. At the same time, the price of the near month, when that month is just before the onset of winter, does not rise as far or as fast as the average price of the near 12-month contracts whose delivery falls during the winter season.
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* PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
An investment in a portfolio that involved owning only the near month contract would likely produce a different result than an investment in a portfolio that owned an equal number of each of the near 12 months worth of contracts. Generally speaking, when the natural gas futures market is in backwardation, the near month only portfolio would tend to have a higher total return than the 12 month portfolio. Conversely, if the natural gas futures market was in contango, the portfolio containing 12 months worth of contracts would tend to outperform the near month only portfolio. The chart below shows the annual results of owning a portfolio consisting of the near month contract and a portfolio containing the near 12 months worth of contracts. In addition, the chart shows the annual change in the spot price of natural gas. In this example, each month, the near month only portfolio would sell the near month contract at expiration and buy the next month out contract. The portfolio holding an equal number of the near 12 months worth of contracts would sell the near month contract at expiration and replace it with the contract that becomes the new twelfth month contract.
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* PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
As seen in the chart above, there have been periods of both positive and negative annual total returns for both hypothetical portfolios over the last 10 years. In addition, there have been periods during which the near month only approach had higher returns, and periods where the 12 month approach had higher total returns. The above chart does not represent the performance history of US12NG or any affiliated funds.
Historically, the natural gas futures markets have experienced periods of contango and backwardation. Because natural gas demand is seasonal, it is possible for the price of natural gas Futures Contracts for delivery within one or two months to rapidly move from backwardation into contango and back again within a relatively short period of time of less than one year. While the investment objective of US12NG is not to have the market price of its units match, dollar for dollar, changes in the spot price of natural gas, contango impacted the total return on an investment in US12NG units during the six months ended June 30, 2011 relative to a hypothetical direct investment in natural gas. For example, an investment in US12NG units made on December 31, 2010 and held to June 30, 2011 decreased based upon the changes in the NAV for US12NG units on those days, by approximately -7.00%, while the spot price of natural gas for immediate delivery during the same period increased by approximately 0.30% and the average price of the Benchmark Futures Contracts increased by approximately $0.014 (note: this comparison ignores the potential costs associated with physically owning and storing natural gas, which could be substantial). By comparison, during the period from December 31, 2009 to June 30, 2010, contango impacted the total return on an investment in US12NG units relative to a hypothetical direct investment in natural gas. For example, an investment in US12NG units made on December 31, 2009 and held to June 30, 2010 decreased, based upon the changes in the NAV for US12NG units on those days, by approximately -22.29%, while the spot price of natural gas for immediate delivery during the same period decreased by approximately -17.16% (note: this comparison ignores the potential costs associated with physically owning and storing natural gas, which could be substantial).
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USCF believes that holding futures contracts whose expiration dates are spread out over a 12 month period of time will cause the total return of such a portfolio to vary compared to a portfolio that holds only a single months contract (such as the near month contract). In particular, USCF believes that the total return of a portfolio holding contracts with a range of expiration months will be impacted differently by the price relationship between different contract months of the same commodity future compared to the total return of a portfolio consisting of the near month contract. USCF believes that based on historical evidence a portfolio that held futures contracts with a range of expiration dates spread out over a 12 month period of time would typically be impacted less by the positive effect of backwardation, and less by the negative effect of contango, compared to a portfolio that held contracts of a single near month. As a result, absent the impact of any other factors, a portfolio of 12 different monthly contracts would tend to have a lower total return than a near month only portfolio in a backwardation market and a higher total return in a contango market. However there can be no assurance that such historical relationships would provide the same or similar results in the future.
Periods of contango or backwardation do not materially impact US12NGs investment objective of having the percentage changes in its per unit NAV track the percentage changes in the average of the prices of the Benchmark Futures Contracts since the impact of backwardation and contango tend to equally impact the percentage changes in price of both US12NGs units and the Benchmark Futures Contracts. It is impossible to predict with any degree of certainty whether backwardation or contango will occur in the future. It is likely that both conditions will occur during different periods and, because of the seasonal nature of natural gas demand, both may occur within a single years time.
Natural Gas Market. During the six months ended June 30, 2011, natural gas prices in the United States were impacted by several factors. At the beginning of 2010, the amount of natural gas in storage remained near the high of average levels as compared to the previous five years. It remained comparable to 2010 levels during the first quarter of 2011. During the second quarter of 2011, the amount of natural gas in storage fell below 2010 levels to the approximate median of the maximum-minimum range of the previous five years. Although prices were volatile, they tended to trend along with the seasonal changes in natural gas storage levels. Colder temperatures during January and February 2011, followed by warmer temperatures during March, April, May, and June 2011, contributed to the volatility in prices. In addition, increased natural gas production also contributed to a decline in natural gas prices during the six months ended June 30, 2011, with prices reaching a low of $3.778 on March 3, 2011.
Natural Gas Price Movements in Comparison to Other Energy Commodities and Investment Categories. USCF believes that investors frequently measure the degree to which prices or total returns of one investment or asset class move up or down in value in concert with another investment or asset class. Statistically, such a measure is usually done by measuring the correlation of the price movements of the two different investments or asset classes over some period of time. The correlation is scaled between 1 and -1, where 1 indicates that the two investment options move up or down in price or value together, known as positive correlation, and -1 indicates that they move in completely opposite directions, known as negative correlation. A correlation of 0 would mean that the movements of the two are neither positively nor negatively correlated, known as non-correlation. That is, the investment options sometimes move up and down together and other times move in opposite directions.
For the ten-year time period between June 30, 2001 and June 30, 2011, the chart below compares the monthly movements of natural gas prices versus the monthly movements of the prices of several other energy commodities, such as crude oil, heating oil, and unleaded gasoline, as well as several major non-commodity investment asset classes, such as large cap U.S. equities, U.S. government bonds and global equities. It can be seen that over this particular time period, the movement of natural gas on a monthly basis was not strongly correlated with the movements of large cap U.S. equities, U.S. government bonds or global equities. However, movements in natural gas had a positive, but moderate, correlation to movements in heating oil, crude oil and unleaded gasoline.
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Correlation Matrix June 30, 2001-2011 |
Large Cap U.S. Equities (S&P 500) |
U.S. Govt. Bonds (EFFAS U.S. Govt. Bond Index) |
Global Equities (FTSE World Index) |
Crude Oil |
Heating Oil |
Unleaded Gasoline |
Natural Gas |
|||||||||||||||||||||
Large Cap U.S. Equities (S&P 500) |
1.000 | -0.328 | 0.968 | 0.208 | 0.204 | 0.189 | 0.041 | |||||||||||||||||||||
U.S. Govt. Bonds (EFFAS |
1.000 | -0.294 | -0.161 | -0.131 | -0.254 | 0.104 | ||||||||||||||||||||||
Global Equities (FTSE World Index) |
1.000 | 0.296 | 0.288 | 0.248 | 0.095 | |||||||||||||||||||||||
Crude Oil |
1.000 | 0.812 | 0.728 | 0.389 | ||||||||||||||||||||||||
Heating Oil |
1.000 | 0.728 | 0.507 | |||||||||||||||||||||||||
Unleaded Gasoline |
1.000 | 0.308 | ||||||||||||||||||||||||||
Natural Gas |
1.000 |
Source: Bloomberg, NYMEX
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
The chart below covers a more recent, but much shorter, range of dates than the above chart. It can be seen that over this particular time period, the movement of natural gas on a monthly basis was negatively correlated with U.S. government bonds. However, movements in natural gas had a positive, yet moderate, correlation with the movements of large cap U.S. equities, global equities, crude oil, heating oil and gasoline.
Correlation Matrix 12 Months ended June 30, 2011 |
Large Cap U.S. Equities (S&P 500) |
U.S. Govt. Bonds (EFFAS U.S. Govt. Bond Index) |
Global Equities (FTSE World Index) |
Crude Oil |
Heating Oil |
Unleaded Gasoline |
Natural Gas |
|||||||||||||||||||||
Large Cap U.S. Equities (S&P 500) |
1.000 | -0.444 | 0.985 | 0.273 | 0.829 | 0.632 | 0.356 | |||||||||||||||||||||
U.S. Govt. Bonds (EFFAS |
1.000 | -0.400 | -0.105 | -0.534 | -0.469 | -0.197 | ||||||||||||||||||||||
Global Equities (FTSE World Index) |
1.000 | 0.275 | 0.795 | 0.613 | 0.350 | |||||||||||||||||||||||
Crude Oil |
1.000 | 0.271 | 0.264 | 0.217 | ||||||||||||||||||||||||
Heating Oil |
1.000 | 0.862 | 0.457 | |||||||||||||||||||||||||
Unleaded Gasoline |
1.000 | 0.593 | ||||||||||||||||||||||||||
Natural Gas |
1.000 |
Source: Bloomberg, NYMEX
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
Investors are cautioned that the historical price relationships between natural gas and various other energy commodities, as well as other investment asset classes, as measured by correlation may not be reliable predictors of future price movements and correlation results. The results pictured above would have been different if a different range of dates had been selected. USCF believes that natural gas has historically not demonstrated a strong correlation with equities or bonds over long periods of time. However, USCF also believes that in the future it is possible that natural gas could have long-term correlation results that indicate prices of natural gas more closely track the movements of equities or bonds. In addition, USCF believes that, when measured over time periods shorter than ten years, there will always be some periods where the correlation of natural gas to equities and bonds will be either more strongly positively correlated or more strongly negatively correlated than the long-term historical results suggest.
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The correlations between natural gas, crude oil, heating oil and gasoline are relevant because USCF endeavors to invest US12NGs assets in natural gas Futures Contracts and Other Natural Gas-Related Investments so that daily changes in percentage terms in US12NGs NAV correlate as closely as possible with daily changes in percentage terms in the average of the prices of the Benchmark Futures Contracts. If certain other fuel-based commodity Futures Contracts do not closely correlate with the Benchmark Futures Contracts, then their use could lead to greater tracking error. As noted above, USCF also believes that the changes in percentage terms in the average of the prices of the Benchmark Futures Contracts will closely correlate with changes in percentage terms in the spot price of natural gas.
Critical Accounting Policies
Preparation of the condensed financial statements and related disclosures in compliance with accounting principles generally accepted in the United States of America requires the application of appropriate accounting rules and guidance, as well as the use of estimates. US12NGs application of these policies involves judgments and actual results may differ from the estimates used.
USCF has evaluated the nature and types of estimates that it makes in preparing US12NGs condensed financial statements and related disclosures and has determined that the valuation of its investments, which are not traded on a United States or internationally recognized futures exchange (such as forward contracts and over-the-counter contracts) involves a critical accounting policy. The values which are used by US12NG for its Futures Contracts are provided by its commodity broker who uses market prices when available, while over-the-counter contracts are valued based on the present value of estimated future cash flows that would be received from or paid to a third party in settlement of these derivative contracts prior to their delivery date and valued on a daily basis. In addition, US12NG estimates dividend and interest income on a daily basis using prevailing rates earned on its cash and cash equivalents. These estimates are adjusted to the actual amount received on a monthly basis and the difference, if any, is not considered material.
Liquidity and Capital Resources
US12NG has not made, and does not anticipate making, use of borrowings or other lines of credit to meet its obligations. US12NG has met, and it is anticipated that US12NG will continue to meet, its liquidity needs in the normal course of business from the proceeds of the sale of its investments, or from the Treasuries, cash and/or cash equivalents that it intends to hold at all times. US12NGs liquidity needs include: redeeming units, providing margin deposits for its existing natural gas Futures Contracts or the purchase of additional natural gas Futures Contracts and posting collateral for its over-the-counter contracts and payment of its expenses, summarized below under Contractual Obligations.
US12NG currently generates cash primarily from: (i) the sale of baskets consisting of 100,000 units (Creation Baskets) and (ii) income earned on cash and/or cash equivalents. US12NG has allocated substantially all of its net assets to trading in Natural Gas Interests. US12NG invests in Natural Gas Interests to the fullest extent possible without being leveraged or unable to satisfy its current or potential margin or collateral obligations with respect to its investments in Futures Contracts and Other Natural Gas-Related Investments. A significant portion of US12NGs NAV is held in cash and cash equivalents that are used as margin and as collateral for its trading in Natural Gas Interests. The balance of the net assets is held in US12NGs account at its custodian bank. Income received from US12NGs money market funds is paid to US12NG. During the six months ended June 30, 2011, US12NGs expenses exceeded the income US12NG earned and the cash earned from the sale of Creation Baskets. During the six months ended June 30, 2011, US12NG was forced to use other assets to pay cash expenses, which could cause a drop in US12NGs NAV over time. To the extent expenses have exceeded income, US12NGs NAV will be negatively impacted.
US12NGs investments in Natural Gas Interests may be subject to periods of illiquidity because of market conditions, regulatory considerations and other reasons. For example, most commodity exchanges limit the fluctuations in futures contracts prices during a single day by regulations referred to as daily limits. During a single day, no trades may be executed at prices beyond the daily limit. Once the price of a futures contract has increased or decreased by an amount equal to the daily limit, positions in the contracts can neither be taken nor liquidated unless the traders are willing to effect trades at or within the specified daily limit. Such market conditions could prevent US12NG from promptly liquidating its positions in Futures Contracts. During the six months ended June 30, 2011, US12NG was not forced to purchase or liquidate any of its positions while daily limits were in effect; however, US12NG cannot predict whether such an event may occur in the future.
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Since the initial offering of US12NG, all payments with respect to US12NGs expenses were paid by USCF. US12NG does not have an obligation or intention to refund such payments by USCF. USCF is under no obligation to pay US12NGs current or future expenses. US12NG is responsible for expenses incurred subsequent to the initial offering of units relating to: (i) management fees, (ii) brokerage fees and commissions, (iii) licensing fees for the use of intellectual property, (iv) ongoing registration expenses in connection with offers and sales of its units subsequent to the initial offering, (v) other expenses, including certain tax reporting costs, (vi) fees and expenses of the independent directors of USCF and (vii) other extraordinary expenses not in the ordinary course of business, while USCF has been responsible for expenses relating to the fees of US12NGs Marketing Agent, Administrator and Custodian and registration expenses relating to the initial offering of units. If USCF and US12NG are unsuccessful in raising sufficient funds to cover these respective expenses or in locating any other source of funding, US12NG will terminate and investors may lose all or part of their investment.
Market Risk
Trading in Futures Contracts and Other Natural Gas-Related Investments, such as forwards, involves US12NG entering into contractual commitments to purchase or sell natural gas at a specified date in the future. The aggregate market value of the contracts will significantly exceed US12NGs future cash requirements since US12NG intends to close out its open positions prior to settlement. As a result, US12NG is generally only subject to the risk of loss arising from the change in value of the contracts. US12NG considers the fair value of its derivative instruments to be the unrealized gain or loss on the contracts. The market risk associated with US12NGs commitments to purchase natural gas is limited to the aggregate market value of the contracts held. However, should US12NG enter into a contractual commitment to sell natural gas, it would be required to make delivery of the natural gas at the contract price, repurchase the contract at prevailing prices or settle in cash. Since there are no limits on the future price of natural gas, the market risk to US12NG could be unlimited.
US12NGs exposure to market risk depends on a number of factors, including the markets for natural gas, the volatility of interest rates and foreign exchange rates, the liquidity of the Futures Contracts and Other Natural Gas-Related Investments markets and the relationships among the contracts held by US12NG. Drastic market occurrences could ultimately lead to the loss of all or substantially all of an investors capital.
Credit Risk
When US12NG enters into Futures Contracts and Other Natural Gas-Related Investments, it is exposed to the credit risk that the counterparty will not be able to meet its obligations. The counterparty for the Futures Contracts traded on the NYMEX and on most other futures exchanges is the clearinghouse associated with the particular exchange. In general, in addition to margin required to be posted by the clearinghouse in connection with cleared trades, clearinghouses are backed by their members who may be required to share in the financial burden resulting from the nonperformance of one of their members and, therefore, this additional member support should significantly reduce credit risk. Some foreign exchanges are not backed by their clearinghouse members but may be backed by a consortium of banks or other financial institutions. There can be no assurance that any counterparty, clearinghouse, or their members or their financial backers will satisfy their obligations to US12NG in such circumstances.
USCF attempts to manage the credit risk of US12NG by following various trading limitations and policies. In particular, US12NG generally posts margin and/or holds liquid assets that are approximately equal to the market value of its obligations to counterparties under the Futures Contracts and Other Natural Gas-Related Investments it holds. USCF has implemented procedures that include, but are not limited to, executing and clearing trades only with creditworthy parties and/or requiring the posting of collateral or margin by such parties for the benefit of US12NG to limit its credit exposure. UBS Securities LLC, US12NGs commodity broker, or any other broker that may be retained by US12NG in the future, when acting as US12NGs futures commission merchant in accepting orders to purchase or sell Futures Contracts on United States exchanges, is required by CFTC regulations to separately account for and segregate as belonging to US12NG, all assets of US12NG relating to domestic Futures Contracts trading. These futures commission merchants are not allowed to commingle US12NGs assets with their other assets. In addition, the CFTC requires commodity brokers to hold in a secure account US12NGs assets related to foreign Futures Contracts trading.
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If, in the future, US12NG purchases over-the-counter contracts, see Item 3. Quantitative and Qualitative Disclosures About Market Risk in this quarterly report on Form 10-Q for a discussion of over-the-counter contracts.
As of June 30, 2011, US12NG had deposits in domestic and foreign financial institutions, including cash investments in money market funds, in the amount of $37,344,848. This amount is subject to loss should these institutions cease operations.
Off Balance Sheet Financing
As of June 30, 2011, US12NG has no loan guarantee, credit support or other off-balance sheet arrangements of any kind other than agreements entered into in the normal course of business, which may include indemnification provisions relating to certain risks that service providers undertake in performing services which are in the best interests of US12NG. While US12NGs exposure under these indemnification provisions cannot be estimated, they are not expected to have a material impact on US12NGs financial position.
Redemption Basket Obligation
In order to meet its investment objective and pay its contractual obligations described below, US12NG requires liquidity to redeem units, which redemptions must be in blocks of 100,000 units called Redemption Baskets. US12NG has to date satisfied this obligation by paying from the cash or cash equivalents it holds or through the sale of its Treasuries in an amount proportionate to the number of units being redeemed.
Contractual Obligations
US12NGs primary contractual obligations are with USCF. In return for its services, USCF is entitled to a management fee calculated monthly as a fixed percentage of US12NGs NAV, currently 0.75% of US12NGs NAV on its average daily net assets. Since inception through April 30, 2010, USCF was charging US12NG a management fee at a reduced rate of 0.60% per annum of average daily net assets. Effective May 1, 2010, USCF resumed charging its standard rate of 0.75% per annum of average daily net assets. The difference of 0.15% per annum of average daily net assets since inception through April 30, 2010 was waived by USCF and will not be recouped from US12NG.
USCF agreed to pay the start-up costs associated with the formation of US12NG, primarily its legal, accounting and other costs in connection with USCFs registration with the CFTC as a CPO and the registration and listing of US12NG and its units with the SEC, FINRA and the NYSE Arca, respectively. However, since US12NGs initial offering of units, offering costs incurred in connection with registering and listing additional units of US12NG have been directly borne on an ongoing basis by US12NG, and not by USCF.
USCF pays the fees of US12NGs marketing agent, ALPS Distributors, Inc., and the fees of the custodian and transfer agent, Brown Brothers Harriman & Co. (BBH&Co.), as well as BBH&Co.s fees for performing administrative services, including those in connection with the preparation of US12NGs condensed financial statements and its SEC and CFTC reports. USCF and US12NG have also entered into a licensing agreement with the NYMEX pursuant to which US12NG and the affiliated funds managed by USCF, other than USBO and USCI, pay a licensing fee to the NYMEX. US12NG also pays the fees and expenses associated with its tax accounting and reporting requirements, with the exception of certain initial implementation service fees and base service fees, which are borne by USCF. USCF, though under no obligation to do so, agreed to pay certain costs for tax reporting and audit expenses normally borne by US12NG to the extent that such expenses exceed 0.15% (15 basis points) of US12NGs NAV, on an annualized basis, through at least December 31, 2011. USCF has no obligation to continue such payments into subsequent periods.
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In addition to USCFs management fee, US12NG pays its brokerage fees (including fees to a futures commission merchant), over-the-counter dealer spreads, any licensing fees for the use of intellectual property, and, subsequent to the initial offering, registration and other fees paid to the SEC, FINRA, or other regulatory agencies in connection with the offer and sale of units, as well as legal, printing, accounting and other expenses associated therewith, and extraordinary expenses. The latter are expenses not incurred in the ordinary course of US12NGs business, including expenses relating to the indemnification of any person against liabilities and obligations to the extent permitted by law and under the LP Agreement, the bringing or defending of actions in law or in equity or otherwise conducting litigation and incurring legal expenses and the settlement of claims and litigation. Commission payments to a futures commission merchant are on a contract-by-contract, or round turn, basis. US12NG also pays a portion of the fees and expenses of the independent directors of USCF. See Note 3 to the Notes to Condensed Financial Statements (Unaudited) in Item 1 of this quarterly report on Form 10-Q.
The parties cannot anticipate the amount of payments that will be required under these arrangements for future periods, as US12NGs NAVs and trading levels to meet its investment objective will not be known until a future date. These agreements are effective for a specific term agreed upon by the parties with an option to renew, or, in some cases, are in effect for the duration of US12NGs existence. Either party may terminate these agreements earlier for certain reasons described in the agreements.
As of June 30, 2011, US12NGs portfolio consisted of 770 Natural Gas Futures NG Contracts traded on the NYMEX. For a list of US12NGs current holdings, please see US12NGs website at www.unitedstates12monthnaturalgasfund.com.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Over-the-Counter Derivatives (Including Spreads and Straddles)
In the future, US12NG may purchase over-the-counter contracts (OTC Contracts). Unlike most exchange-traded futures contracts, cleared swaps or exchange-traded options on such futures, each party to an OTC Contract bears the credit risk that the other party may not be able to perform its obligations under its contract.
Some natural gas-based derivatives transactions contain fairly generic terms and conditions and are available from a wide range of participants. Other natural gas-based derivatives have highly customized terms and conditions and are not as widely available. Many of these OTC Contracts are cash-settled forwards for the future delivery of natural gas- or petroleum-based fuels that have terms similar to the Futures Contracts. Others take the form of swaps in which the two parties exchange cash flows based on pre-determined formulas tied to the spot price of natural gas, forward natural gas price or natural gas futures price. In these swaps, a party pays a fixed price per unit and the other pays a variable price based on the average price of future contracts for a specified period or the price on a specific date, with payments typically made between the parties on a net basis. For example, US12NG may enter into OTC Contracts whose value will be tied to changes in the difference between the spot price of natural gas, the price of Futures Contracts traded on the NYMEX and the prices of other Futures Contracts in which US12NG may invest.
To reduce the credit risk that arises in connection with such contracts, US12NG will generally enter into an agreement with each counterparty based on the Master Agreement published by the International Swaps and Derivatives Association, Inc. that provides for the netting of its overall exposure to its counterparty.
USCF assesses or reviews, as appropriate, the creditworthiness of each potential or existing counterparty to an OTC Contract pursuant to guidelines approved by USCFs board of directors (the Board). Furthermore, USCF on behalf of US12NG only enters into OTC Contracts with counterparties who are, or are affiliates of, (a) banks regulated by a United States federal bank regulator, (b) broker-dealers regulated by the SEC, (c) insurance companies domiciled in the United States, or (d) producers, users or traders of energy, whether or not regulated by the CFTC. Any entity acting as a counterparty shall be regulated in either the United States or the United Kingdom unless otherwise approved by the Board after consultation with its legal counsel. Existing counterparties are also reviewed periodically by USCF. US12NG will also require that the counterparty be highly rated and/or provide collateral or other credit support. Even if collateral is used to reduce counterparty credit risk, sudden changes in the value of OTC transactions may leave a party open to financial risk due to a counterparty default since the collateral held may not cover a partys exposure on the transaction in such situations.
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The Dodd-Frank Act requires the CFTC and SEC to establish both initial and variation margin requirements on all swaps that are not cleared by a registered clearing organization (i.e., uncleared swaps). In addition, the Dodd-Frank Act provides parties who post initial margin to a swap dealer or major swap participant with a statutory right to insist that such margin be held in a segregated account with an independent custodian. At this time, the CFTC has proposed rules addressing margin requirements and the statutory right of certain market participants but has not implemented any rules on these issues. On April 12, 2011, the Prudential Regulators and the CFTC issued proposed rules establishing minimum initial and variation margin collection requirements for Covered Swap Entities, which if adopted, would require Covered Swap Entities to collect minimum initial and variation margin amounts from swap counterparties. The public comment period for these rules was extended on June 23, 2011. The Prudential Regulators proposed rules would apply to those Covered Swap Entities that are regulated by the Prudential Regulators and the CFTCs proposed rules would apply to Covered Swap Entities that are not regulated by the Prudential Regulators.
The amount of initial and variation margin that Covered Swap Entities would be required to collect under the proposed rules varies based on whether their counterparty to a particular swap is (1) a Covered Swap Entity, (2) a high-risk financial entity end-user, (3) a low-risk financial entity end-user (e.g., financial entities subject to capital requirements imposed by bank or insurance regulators, that predominantly use swaps to hedge and that do not have significant swap exposure) or (4) a non-financial end-user. With certain exceptions not applicable to US12NG and the affiliated funds managed by USCF, Covered Swap Entities would not be required to post initial or variation margin to any of their counterparties except for other Covered Swap Entities.
Covered Swap Entities and all financial entity end-users would be required to post initial margin and variation margin when they enter into swaps with Covered Swap Entities. Margin posted by low-risk financial entity end-users could be subject to thresholds under the proposed rules. As commodity pools, US12NG and the affiliated funds managed by USCF would be high-risk financial entity end-users and would therefore have to post margin without thresholds.
The CFTC voted to propose rules for capital requirements for Covered Swap Entities that are not regulated by a Prudential Regulator. Covered Swap Entities that are regulated by a Prudential Regulator will be subject to the capital requirements already imposed by such Prudential Regulator. In general, higher levels of capital would be imposed on Covered Swap Entities that do not collect margin from their counterparties (or that collect margin subject to thresholds) in connection with their swaps, and could increase the costs of such swaps. On July 14, 2011, the CFTC issued an order providing temporary relief from certain swaps-related provisions of Title VII that would have automatically taken effect on July 16, 2011. The final order granted temporary exemptive relief that, by its terms, expires upon the earlier of the effective date of the required final rulemaking or December 31, 2011.
In general, valuing OTC derivatives is less certain than valuing actively traded financial instruments such as exchange-traded futures contracts and securities or cleared swaps because the price and terms on which such OTC derivatives are entered into or can be terminated are individually negotiated, and those prices and terms may not reflect the best price or terms available from other sources. In addition, while market makers and dealers generally quote indicative prices or terms for entering into or terminating OTC Contracts, they typically are not contractually obligated to do so, particularly if they are not a party to the transaction. As a result, it may be difficult to obtain an independent value for an outstanding OTC derivatives transaction.
US12NG may employ spreads or straddles in its trading to mitigate the differences in its investment portfolio and its goal of tracking the changes in the average of the prices of the Benchmark Futures Contracts. US12NG would use a spread when it chooses to take simultaneous long and short positions in futures written on the same underlying asset, but with different delivery months. The effect of holding such combined positions is to adjust the sensitivity of US12NG to changes in the price relationship between futures contracts, which will expire sooner, and those that will expire later. US12NG would use such a spread if USCF felt that taking such long and short positions, when combined with the rest of its holdings, would more closely track the investment goals of US12NG, or if USCF felt it would lead to an overall lower cost of trading to achieve a given level of economic exposure to movements in natural gas prices. US12NG would enter into a straddle when it chooses to take an option position consisting of a long (or short) position in both a call option and put option. The economic effect of holding certain combinations of put options and call options can be very similar to that of owning the underlying futures contracts. US12NG would make use of such a straddle approach if, in the opinion of USCF, the resulting combination would more closely track the investment goals of US12NG or if it would lead to an overall lower cost of trading to achieve a given level of economic exposure to movements in natural gas prices.
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During the six months ended June 30, 2011, US12NG did not employ any hedging methods such as those described above since all of US12NGs investments were made over an exchange. Therefore, during such period, US12NG was not exposed to counterparty risk.
US12NG anticipates that the use of Other Natural Gas-Related Investments together with its investments in Futures Contracts will produce price and total return results that closely track the investment goals of US12NG. However, there can be no assurance of this. OTC Contracts may result in higher transaction-related expenses than the brokerage commissions paid in connection with the purchase of Futures Contracts, which may impact US12NGs ability to successfully track the Benchmark Futures Contracts.
Item 4. Controls and Procedures.
Disclosure Controls and Procedures
US12NG maintains disclosure controls and procedures that are designed to ensure that material information required to be disclosed in US12NGs periodic reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time period specified in the SECs rules and forms.
The duly appointed officers of USCF, including its chief executive officer and chief financial officer, who perform functions equivalent to those of a principal executive officer and principal financial officer of US12NG if US12NG had any officers, have evaluated the effectiveness of US12NGs disclosure controls and procedures and have concluded that the disclosure controls and procedures of US12NG have been effective as of the end of the period covered by this quarterly report on Form 10-Q.
Change in Internal Control Over Financial Reporting
There were no changes in US12NGs internal control over financial reporting during US12NGs last fiscal quarter that have materially affected, or are reasonably likely to materially affect, US12NGs internal control over financial reporting.
Not applicable.
There have been no material changes to the risk factors previously disclosed in US12NGs Annual Report on Form 10-K for the fiscal year ended December 31, 2010, filed on March 31, 2011, except for the update to the risk factor set forth below and the addition of the two risk factors set forth below.
Updated Risk Factor:
The financial markets are currently in a period of disruption and US12NG does not expect these conditions to improve in the near future.
Since 2008, the financial markets have experienced difficult financial conditions and volatility as well as significant adverse trends. The conditions in these markets have resulted in sporadic availability of corporate credit and liquidity and have led indirectly to the insolvency, closure or acquisition of a number of major financial institutions and have contributed to further consolidation within the financial services industry. Although the financial markets saw some signs of a recovery beginning in late 2010, economic growth in 2011 has been slow and the financial markets are still fragile and could fall into another recession. Another recession could adversely affect the financial condition and results of operations of US12NGs service providers and Authorized Purchasers which would impact the ability of USCF to achieve US12NGs investment objective.
New Risk Factors:
US12NG would be negatively impacted if the United States Treasury were to default on its obligations to make payments on Treasury Securities.
Recent events in Washington, D.C. regarding passing a fiscal budget have drawn concern regarding the United States Governments ability to pay it obligations to holders of Treasury Securities. If US12NG is not able to redeem its investments in Treasury Securities prior to maturity and the U.S. Government cannot pay its obligations, US12NG would be negatively impacted. In addition, US12NG might also be negatively impacted by its use of money market mutual funds to the extent those funds might themselves be using Treasury Securities.
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Further ratings downgrades on sovereigns could cause further global market volatility, negatively impacting the ability of sovereigns to borrow funds and pay debt obligations.
In August 2011, Standard & Poors downgraded the United States long-term credit rating from AAA to AA+. This downgrade resulted in global market volatility and it is unclear what effect such downgrade will have on various State debt obligations, as well as other sovereign debt obligations. Such downgrades could have a global impact resulting in a recessionary market and defaults on sovereign debt obligations. Any default on a sovereign to pay its debt obligations could negatively impact US12NG.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Not applicable.
Item 3. Defaults Upon Senior Securities.
Not applicable.
Monthly Account Statements
Pursuant to the requirement under Rule 4.22 under the Commodity Exchange Act, each month US12NG publishes an account statement for its unitholders, which includes a Statement of Income (Loss) and a Statement of Changes in NAV. The account statement is furnished to the SEC on a current report on Form 8-K pursuant to Section 13 or 15(d) of the Exchange Act and posted each month on US12NGs website at www.unitedstates12monthnaturalgasfund.com.
Listed below are the exhibits, which are filed as part of this quarterly report on Form 10-Q (according to the number assigned to them in Item 601 of Regulation S-K):
Exhibit |
Description of Document | |
31.1(1) | Certification by Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
31.2(1) | Certification by Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
32.1(1) | Certification by Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
32.2(1) | Certification by Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
101.INS(2) | XBRL Instance Document | |
101.SCH(2) | XBRL Taxonomy Extension Schema | |
101.CAL(2) | XBRL Taxonomy Extension Calculation Linkbase | |
101.DEF(2) | XBRL Taxonomy Extension Definition Linkbase | |
101.LAB(2) | XBRL Taxonomy Extension Label Linkbase | |
101.PRE(2) | XBRL Taxonomy Extension Presentation Linkbase |
(1) | Filed herewith. |
(2) | In accordance with Rule 406T of Regulation S-T, the information in these exhibits is furnished and deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
United States 12 Month Natural Gas Fund, LP (Registrant)
By: United States Commodity Funds LLC, its general partner
By: |
/s/ Nicholas D. Gerber | |
Nicholas D. Gerber | ||
President and Chief Executive Officer | ||
(Principal executive officer) | ||
Date: August 15, 2011 | ||
By: |
/s/ Howard Mah | |
Howard Mah | ||
Chief Financial Officer | ||
(Principal financial and accounting officer) | ||
Date: August 15, 2011 |
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