How To Trade Natural Gas

If crude oil is the king of commodities, natural gas is sometimes said to be the queen. But natural gas is nevertheless a major commodity in its own right, which is used for everything from cooking food to heating houses during the winter. As the chart below shows, natural gas made up 23% of global energy consumption in 2002. What’s more, its consumption is growing much faster than either of its non-renewable fossil fuel competitors, oil and coal.

Trading natural gas is not for the faint hearted. Even by commodities standards, natural gas is a notoriously volatile market subject to wild price fluctuations. Here I’ll present you with all the basic information you need to develop a decent trading strategy for this commodity.

Differences Between Oil And Natural Gas

Oil and natural gas are both energy commodities. For that reason they are quite similar in the way that they trade. However the price dynamics of the two markets have crucial differences that must be noted. The price of Crude Oil, whether it is Brent or U.S. WTI, is often controlled by investor sentiment, rising in times of general market bullishness and falling in times of risk aversion. It is also seen as a hedge against a weak U.S. Dollar. The infrastructure to store oil is a lot more extensive and global in nature, allowing speculators to ride out any short term supply gluts. In general crude oil is a globalised commodity whose price is determined by a complex web of international factors.

On the other hand, the determination of natural gas’ price is much simpler. It is primarily driven by its own supply and demand dynamics and is typically less impacted by external sources. Its international trade and the supporting storage and transportation infrastructure are miniscule. There are fewer factors to worry when trading natural gas.

Watch Out For Gas Inventories

If you plan on trading natural gas, you really can’t afford to miss the weekly U.S. gas inventories report. The figures are issued by the Energy Information Administration (EIA) every Thursday afternoon at 15:30 (released Friday at 15:30 if there was a U.S. bank holiday on Monday). Here’s a link to the latest EIA report. The main natural gas moving figure in there is the change in inventories from the previous week. You can check out what this figure comes out as in the Weekly Calendar.

Before going any further, it’s important to know how you measure natural gas. While crude oil is measured in barrels (with each barrel containing 42 gallons of oil), natural gas is measured in cubic feet. When it comes to the gas inventories report, we’re talking about billions of cubic feet, Bcf for short. So for the 21st August 2009 inventory report, there was 3,258 Bcf of gas in storage, an increase of 54 Bcf on the previous week.

Like the oil inventories, if the change in inventories is positive then there’s more gas in stock and less demand for it. In this case the price of natural gas tends to fall. On the other side, when gas inventories are falling, demand is up and the price of natural gas tends to rise.

Leading up to the natural gas inventories release, market analysts will give their view on what the change in inventories figure will be. The average expectation of all these different market analysts becomes the market consensus figure and this expectation gets built into the price of natural gas. So let’s say that analysts expect that inventories will rise by 84 Bcf from the previous week. In this case, all else equal, the price of natural gas should fall leading up to the release. You can check out paddypowetrader Weekly Calendar for what the market consensus is.

When the actual change in inventories number is released, it is the deviation from the expected number that is really important. If the actual inventories figure shows a 24 Bcf rise when an 84 Bcf increase was expected, then that is actually positive for the price of natural gas. All else equal, the price of natural gas should rise after the release.

The Oil To Natural Gas Ratio

A barrel of oil has roughly 6 times the energy content of natural gas. If the fuels were perfect substitutes, oil prices would tend to be about 6 times natural gas prices. However, due to various market characteristics discussed briefly above and the ease of using oil, the price of oil has been following a pattern of 8-12 times that of natural gas. However that ratio has spiked dramatically since March 2009. At I write on the 28th August 2009, paddypowertrader quotes the October contract for U.S. Crude Oil at 73.09 - 73.15. It quotes the Natural Gas October contract at 3.075 - 3.125. That’s a ratio of 23.6 times, a historical high.

History suggests that the price gap will eventually narrow, through some combination of U.S. Crude Oil falling and Natural Gas rising. So my first thought would be a sneaky pairs trade, shorting U.S. Crude Oil while going long Natural Gas at the same time. Possibly look for the ratio to narrow to about 15 times and then take profit. Of course, the obvious disclaimer is that the oil-gas ratio may increase further before it eventually decreases back to its historic norm. If you were to do this trade, you would have to be willing to ride out some potential losses before profits kick in. While the ratio will narrow, I haven’t given a date for it.

So What’s Going On With Natural Gas At The Moment

The price of natural gas has fallen over 75% from its 2008 high of over $12 to about $3 now. Unlike oil, which has undergone a rally since February 2009, natural gas bulls have had no such luck. The price continues to fall. What is going on?

One of the big problems is that natural gas is hard to store. However the amount of natural gas in storage has reached highs last seen in 2002. There are even concerns that the full U.S. reservoirs may actually start pushing gas backs up into pipelines. It is normal for stockpiles to grow during the summer, but the current levels are far too high. Gas demand is simply too weak at the moment. Until the excess supply of gas is dispensed with, the price will continue to be depressed. Keep an eye on the Weekly Calendar on Thursdays to see if the change in inventories turns negative any time soon.

To keep up to date, every couple of weeks, the American Gas Association release a Natural Gas Market Indicators report which is quite a detailed and balanced summary of the market.

Trading Natural Gas Companies

As natural gas is quite a wild commodity, you may be more interested in trading the companies that process natural gas as this offers you similar exposure without the volatility.

Both Allegheny Energy (AYE) and Nicor (GAS) are fully integrated natural gas companies, involved in all the production, development, transportation, and distribution phases of natural gas. Allegheny Energy is based primarily in eastern coast of the U.S. while Nicor’s operations are primarily centred in the Illinois area.

Opertating in a more specific area, Chesapeake Energy (CHK) is the largest independent producer of natural gas in the U.S., owning wells in several states. In the U.K., Centrica (CNA.L) (created through the break up of British Gas) is largest supplier of gas to domestic customers.

Even The Pros Can Get Gassed Trading Natural Gas

Natural gas volatile nature gained notoriety in the summer of 2006 for its destruction of two hedge funds. Leading up to that summer, natural gas, like all commodities, was in a raging bull market. But the MotherRock Energy Fund placed huge bets that the price of natural gas was going to drop. As we’ll see, they were right, but their timing was awful. Natural gas kept rallying into the early summer and MotherRock was forced to close having lost over $200 million in only two months. Next up, an even bigger hedge fund, Amaranth Advisors, bet big that the bull market would continue. A sharp reversal later, Amaranth had lost a whopping $3 billion!

There are plenty of lessons that can be learnt from these hedge fund disasters. First, the pros get it wrong and you often will too. Just make sure that your losses aren’t fatal. Second, natural gas is extremely volatile, so make sure you have a solid risk management strategy. Third, getting your making timing right is extremely important. Fourth, cut your losses before you lose all your bankroll. Swings in natural gas can be prolonged. Finally, be prepared for both spectacular wins and also devastating losses. Don’t let either mess up your trading strategy.

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Comment by art

2009-10-02 18:12:20

that’s a very interesting article, i would love to read more about trading natural gas, some practical advices, stories from traders, hints and tricks.

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