Bullish on Natural Gas? There's a Smarter Way to Play

Every time I browse Seeking Alpha I see the same thing: authors screaming about the new commodities bubble inflating again. But I suppose that this time it's different.

Let’s take a look at forward curves of major commodities. Check wheat, for instance. Last summer, when a huge bubble appeared and front month went through 1300, we saw solid backwardation. Why? Because those conditions were specific; it was wheat that caused prices to move higher. Traders supposed that the following summer, farmers, excited with spot prices, would plant much more grains. That’s why calendar spreads moved so quickly and reached such huge backwardation levels.

Now we see that curve is nearly flat. Even more important, spreads didn’t move at all during the spring, when front month went up more than 30%. The answer is simple. We now see another reason and it is the world’s excessive liquidity, so the forward curves in all commodities are now much less specific for any particular commodity. Even metals, where steepness of curve was always significant, now is flat. But there is still an exception.

A small glance at oil and natural gas. While I completely agree with most authors telling us about the lack of fundamental reasons for such growth on WTI, I’d like to stress the difference between them. Natural gas was for a long time a satellite for oil in terms of forward curve. I saw many times how small movements by anyone in this pair were repeated by the second one with some lag.

But now we see a significant discrepancy: WTI is on the run with a nearly flat curve, new lows every month and a huge contango in NG. Oil flatness is understandable – oil is a global market, so opportunities for quasi-arbitrage appear in steep contango. Everybody witnessed just a few months ago how big companies freighted vessels to store WTI and constantly rolled already sold futures on oil over and over again, gaining up to 150% per annum. The American natural gas market, by its nature, is local and NG is expensive to store, so such possibilities are much more difficult to realize. So at the moment we see growing natural gas inventories that push nearest contracts to ridiculously low levels and at the same time very high estimations in more distant years. The situation is unique, so let’s to try to discuss how it can be used for trading.

I guess that there are two most probable outcomes. In the first one, inventories in NG continue to grow up, causing all curves to slide down, because in one day traders will realize that these inventories will not begin to decrease in the foreseeable future due to fallen demand. That will force them to sell distant contracts more aggressively, narrowing the contango.

In addition, gas producers will start more intense hedging due to a very simple reason – just 25 percent of them are profitable if the gas price is less than 3.5 and selling distant futures contracts on the falling spot market is the only way for them to save the margin.

The second and more improbable outcome, in my opinion, is uplifting of first months. What do we see in every major move up in first contracts? Narrowing contango again. Get the idea?

Calendar spread on NG. I’d like to emphasize that this game is quite correlated to just buying front month but it is much more safe and traders can pocket hefty profits even in case of total oversupply of NG.

And as the old saying tells us, the devil is in the details, so it’s important to understand that we are not going to play on seasonality. This spread should be in the same month but different years. Traders should also avoid rolling such spreads, so my personal choice is Oct09/Oct10. Looking at NG calendar spreads' historical volatility, I suppose that 3 months is more than sufficient for this unique situation to resolve. Right now this spread is at record levels for the decade, but if we take into consideration the low spot price for NG and calculate the ratio between these two contracts, it will be an all-time record – a whopping 1.5.

I hope that you catch the idea!

Disclosure: Long NGV9, short NGV0.

Comments

[Shale Gas:]

An interesting trade.

Jun 09 08:36 AM

[taojaxx:]

How about long NG short CL?

Jun 09 01:47 PM

[Mad Hedge F...:]

I'll pass. Just as I was going through this exercise last night, a long time friend from the energy industry, who used to put me up in his Dallas mansion when I was wildcatting for natural gas in the Barnet Shale a decade ago, called me up and told me I was out of my tree putting people into NG at $3.60. Huge discoveries, such as the Hainesville shale in Alabama, have made available enough NG to last the US another 50 years. The new generation of fracting technology, while great for taping into marginal, low grade fields, is much more difficult to turn off when prices are low without causing permanent damage. And then there is the looming threat of large scale LNG imports from abroad. The big gas companies will be forced to dump whatever they have on the market at any price, possibly taking prices this summer down to $2, or even $1. This, after all is the mother of all overshoot contracts. Of course, one could argue that these risks are what already took it down to $3.20, and that industry demand will happily soak up the excess supply. Did I mention that the hurricane season started yesterday? Only Mr. Market knows for sure, and he ain’t talking. In the past month, my calls have enabled traders to catch a 50% move in NG, followed by a 20% move (www.madhedgefundtrader... ). No one will think less of you if you want to cash out here at $4.30 and stay on the sidelines until a more definitive bottom is put in.

Jun 09 06:52 PM

[Eugene Vogel:]

That's too dangerous and uncertain. I'm not sure, whether downtrend on NG has finished (honestly, I think, it will continue).

On Jun 09 01:47 PM taojaxx wrote:

> How about long NG short CL?

Jun 10 06:21 AM

[Old Trader:]

Mad Hedge,

Are there sufficient facilities for the importation of "large scale imports of LNG"? Last winter, I recall that several planned projects for terminals were cancelled because of financing difficulties. While I agree that NG prices may continue to be pressured (absent weather problems in the Gulf, of course), I'm not certain the LNG will be the cause, or even much of a factor.

Jun 10 10:36 AM

[Energy Trader:]

No none was wildcatting the Barnett Shale a decade, everyone knew the gas was there the technology was not developed yet. The Haynesville shale is in LA and east TX. Also, as you point out there is enormous amounts of nat gas on shore, making hurricane season almost irrelevant, as we are even less dependent on Gulf drilling.

My bet as soon as UNG investors stop propping up the front month contract, nat gas will nose dive.

Jun 10 12:06 PM

[koolsool:]

Maybe clean burning plentiful & cheap natural gas should be used instead of coal & oil.

Jun 10 04:24 PM

[Old Trader:]

You're right, but try telling that to the current administration, which doesn't seem to be a fan of any hydrocarbon-based energy sources.


On Jun 10 04:24 PM koolsool wrote:

> Maybe clean burning plentiful & cheap natural gas should be used
> instead of coal & oil.

Jun 10 06:59 PM

[stockferret:]

Lots of comments about the 'fundamentals' of NG.

Its been 3 months since 'fundamentals' have mattered in commodities or stocks.

I suspect NG prices will rise from these levels just because speculators will be looking for something new to game.

Jun 10 07:02 PM

[Henry Buttal:]

Hi Eugene,

An interesting post, but I am with Mad Hedge and the energytrader on this one. I live in the Barnett Shale, and there are monster wells here that still aren't even hooked up to feeder infrastructure yet. Plus you have the Haynesville, and the play in PA.

We went from putting in new LNG terminals to nat gas surplus over about a five year period.

If someone decides to play the upside on this, they better be quick to take profits or cut losses.

Jun 10 09:32 PM

[Soldalma:]

Most of the comments seem to miss the whole point: that the proposed trade is a calendar spread.

Jun 11 05:25 AM

[Eugene Vogel:]

Thanks for your thoughts, guys, but I'm talking about spread here. And I wrote that in case of further depression in NG prices, I guess that this spread should contract also and quite soon.

Jun 11 07:07 AM

[NGAnalyst:]

It is an interesting trade, as the spread has a reason to shrink in either up or down move of the forward curve.

Btw, NG prices surely still have downside risk as storage is still accumulating, but I doubt NG prices will go much lower than current levels, with reasons being: (1) $1 or $2 don't even cover spot costs of some marginal producers; (2) I agree there is alot of gas out there, but producers won't necessarily produce if prices don't improve.

Jun 11 05:52 PM

[User300609:]

Eugene,

I have been watching the 12m spreads for the August-December pairs (ie Aug09-Aug10, Sep09-Sep10 and so forth until Dec09-Dec10) for two weeks or so.

Spreads have come down around 18Jun, but have come up again lately. Are you still in support of your trade idea?

Jun 30 05:52 AM

[User300609:]

Eugene,

I have been watching the 12m spreads for the August-December pairs (ie Aug09-Aug10, Sep09-Sep10 and so forth until Dec09-Dec10) for two weeks or so.

Spreads have come down around 18Jun, but have come up again lately. Are you still in support of your trade idea?

Jun 30 05:53 AM

[Eugene Vogel:]

Sorry for the delay. Yes, I still support it.

> I have been watching the 12m spreads for the August-December pairs
> (ie Aug09-Aug10, Sep09-Sep10 and so forth until Dec09-Dec10) for
> two weeks or so.
>
> Spreads have come down around 18Jun, but have come up again lately.
> Are you still in support of your trade idea?

Jul 14 07:23 AM