What (or When) Is Up with Natural Gas 33 comments
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We've been marveling at the surging investment interest in natural gas recently (see "(Natural) Gas Pains?"), most especially manifested through the United States Natural Gas Fund (NYSE Arca: UNG).
As we pointed out, that investors are flocking to UNG in such large numbers now is paradoxical. After all, natural gas has not been kind to bulls this year. In the first six months of 2009, front-month futures prices have slumped nearly 32%. Due to a sometimes-virulent contango (back-month premium), first-half losses in the UNG share price exceeded 40%.
The fact that there's a contango of such magnitude - at last look, the quarterly premium was 30% of the front-month price - should give bulls pause. A large contango for a storable commodity such as natural gas implies more-than-adequate supplies.
At the least, the current interest in natural gas seems premature given the commodity's inherent seasonality. Natural gas is primarily a heating fuel. Generally, gas is injected into storage during the nonheating season (between April and October). The fuel's then withdrawn from storage over the balance of the year; that is, in the heating season (November through March).
Now, check your calendars. It's still summer: the nonheating season. Is it any wonder gas prices continued to swoon in July? Just since the end of the first half, August futures have dipped more than 10%; UNG's lost more than 12%.
There is hope for bulls, though, if they can be patient. There is a bottom in sight. The bottom, however, may not be readily seen unless you compare a few apples to oranges or, rather, natural gas to crude oil.
A little arithmetic is necessary, though, because natural gas is priced in dollars per million British thermal units (mmBTU), while crude's denominated in barrels, or lots of 42 U.S. gallons. By pricing natural gas and crude oil on an energy-equivalence basis, you can determine the market's bias.
One barrel of crude oil, on average, supplies 5.8 mmBTU, so an energy-equivalent cost can be approximated by dividing the crude oil price by 5.8.
The August delivery of West Texas Intermediate crude settled at $62.93 Tuesday, putting energy equivalency at $10.85 per mmBTU. Now, take a look at August natural gas prices. Yesterday, Henry Hub futures settled on NYMEX at $3.43 per mmBTU, a $7.42 discount. That does make natural gas seem cheap, doesn't it?
Not as cheap as last summer, though. Back then, natural gas futures were trading at some of the steepest discounts seen in several years. One year ago, in fact, the discount was $11.40 per mmBTU, just a week ahead of a summertime nadir of $13.11.
If history is any guide, then, we're close to a bottom. Historically, however, that doesn't necessarily mean the natural gas discount will immediately evaporate. It tends to erode gradually in the summer months. Typically, the dramatic stuff doesn't occur until after Labor Day. After that, the discount tends to be cut drastically, and natural gas prices can, in fact, move to a premium over crude oil.
Since 1994, the differential has run from a discount as deep as $13.19 per mmBTU, or $76.50 per barrel-equivalent, to a premium of $5.41 per mmBTU ($31.40 per barrel-equivalent).
Energy-Equivalent Spreads: Natural Gas Vs. Crude Oil
There's a fairly reliable seasonal spread, a favorite of energy traders, that capitalizes upon this late-year jockeying in energy-equivalent costs. Trading it over the past 15 years by pitting long natural gas against short crude oil, spreaders averaged a $12 per barrel-equivalent gain with 80% reliability (12 out of 15 years).
The spread's fairly straightforward. You simply buy natural gas futures on the first business day of September while simultaneously selling short sale crude oil futures. Hold the position until the second Monday in December, then exit.
Trading the spread on an energy-equivalent basis means purchasing 58 natural gas contracts for every 10 crude oil futures sold short. That's what you'd do, of course, if you were a professional spreader. The capital requirements for margining spreads of that size is daunting for most retail investors. Still, you can capture much of the seasonal drift by trading the spread at parity; that is, one contract per side. Doing so brings down the win/loss ratio to a still-respectable 10-to-5, and lowers the average profit to about $7 per barrel-equivalent, but given the risk profile of the trade, those remain pretty decent odds. There's, as well, a 40% margin credit granted by the NYMEX clearinghouse for the spread, which enhances its potential return. That translates, at exchange minimums, to a performance bond of $8,302 for each contract pair.
Long Natural Gas/Short Crude Oil: Seasonal Spread
Last year, the parity trade actually worked to the benefit of retail investors, since it overweighted short crude precisely when oil prices were sliding most vertically from their nosebleed summertime heights. By the beginning of December, the equity in a single contract pair exceeded $50,000.
There are, of course, no guarantees that this year will offer the same opportunity. After all, oil prices are nowhere near as heady as they were last summer. The natural gas discount is more shallow now but it still makes for an attractive trade.
Better still, there's a new development that allows retail investors an opportunity to trade the spread without venturing into futures at all. The ProShares UltraShort Dow Jones-UBS Crude Oil ETF (NYSE Arca: SCO) bestows leveraged short exposure to crude oil through a securities account. When coupled with a purchase of UNG shares, you've got yourself a mimic of the futures spread you can trade in your stock account.
Just be patient, though. It's not quite the time for it.
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This article has 33 comments:
Is it just me or is the fact that we sit on a methane bubble just a little more than ironic in retrospect?
Support the plan.
That's a wonderful comment, but I guess all the UNG bagholders hate it.
On Jul 08 05:51 PM Mad Hedge Fund Trader wrote:
> We've recently come to the realization that the US sits on a giant
> natural gas formation. You may recall my advice to abandon natural
> gas at $4.30 in the face of giant new discoveries in shale formations
> (see “Cash out here at $4.30) and “Huge Discoveries . Since then,
> the Midwest has suffered its wettest spring since 1871. It rained
> 25 inches in Chicago the first half of the year, drowning golf courses,
> and sending the mosquito population exploding to Biblical plague
> proportions. Let me assure you, I have absolutely no ability to predict
> the weather, except that my combat scars itch when a storm is coming.
> Cold weather means no air conditioning, which means cratering natural
> gas demand and a new two month low of $3.37. But when you see a parallel
> contract like crude soar to new heights, and NG fail a half dozen
> times to get off a five year low, you know rough weather is coming.
> The crude/gas ratio players really got carried out in body bags on
> this one, as one record after another was shattered, taking it to
> a stunning 19.4:1. Natural gas has been the worst performing investment
> this year, the ETF (seekingalpha.com/symbo...) falling a
> mind blowing 54% since January. Best to wait for natural gas to
> find its new, lower, range before entertaining a position.
On Jul 08 08:13 PM madrejesica wrote:
> pickensplan.com
>
> Support the plan.
OIL Supply - the 2006-8 price surge barely brought any more oil to market proving that the easy oil is gone. OPEC's claims about it's reserves are dubious and non-OPEC oil is falling off even with expensive new sources like tar sands and deepoffshore Brazil.
OIL Demand - higher now than before the price surge and subsequent global recession which proves how inelastic demand is (we love our cars, Chinese and Indians want one).
GAS Supply - Developments at home (shale) and globally (LNG) seem to be making "Peak Gas" next century's problem.
GAS Demand - Should be assured because it's cleaner than coal as a source of power generation and a realistic transportation alternative (Pickens). But there are plenty of entrenched interests out there to delay and frustrate any strategic move to gas.
CONCLUSION: Very different markets with no guarantee that price spread will revert to mean over a tradeable timespan.
What happens with any other commodity when supply grows?
There might be a bump when hurricane season comes on, I might buy EOG (best land driller) around middle of Aug. (I am a hurricane Katrina refugee)
But also when so many of the herd goes into an investment It does not seem like the Lords of Wall Street will allow us mortals to profit.
Why don't they do this? I guess it makes too much sense.
I wish it wasn't so.
Natural gas is primarily used for heating, but also is used for electricity generation. The normal seasonal price increases in natural gas begin in July, move up through October (Air conditioning season), retrace and then ramp back up till January when prices drop again. A chart of the normal seasonal pricing can be found here (presuming seeking alpha has fixed their problem of including links):
www.spectrumcommoditie...
Even though commercial use of natural gas is down (factories, chemical production), we should still see something like the same pattern as normal, albeit maybe at a reduced rate.
We first must make use of all fossil energy forms through the cleanest methods possible(this is where our national efforts should be going; but, it is not to be mistaken for "totally clean"; also can't be done, but as close as practically possible; this IS the real world.) while green is developed to the point where it may be more economically feasible, maybe in 3 decades. I do not think green will be as cheap as fossil was and is for many, many decades, if ever. In the future, we will truly realize how cheap fossil energy was as we bite the bullet hard due to high energy costs for the rest of human existence.
1) They are not marginal substitutes for each other so the $/MMBTU argument is meaningless. Can anyone name a major consuming sector for oil that can easily switch to NG? It's like saying Big Macs and carrots should trade at caloric parity.
2) Oil is priced globally, gas is still largely local. If you pull oil out of the ground in Louisiana you could sell it in the UK if the transportation economics made sense. That just not possible for natural gas. North American Natural Gas is stored and consumed in North America. LNG is still a one-way supply line into, but not out of, North America.
For a statistical analysis of the WTI/NG relationship, see my instablog. We really need to stop obsessing about this non-existent relationship.
On Jul 09 02:09 PM LOLcapitalist, CFA wrote:
> It never ceases to amaze me the extent to which the WTI/NG ratio
> myth is ingrained in the minds of so many traders. Let me be perfectly
> clear: the prices for North American Natural Gas and Crude Oil in
> North American have absolutely nothing do do with one another except
> to the extent that they are both driven (to some extent but far from
> exclusively) by GDP growth expectations. Here are two significant
> reasons:
>
> 1) They are not marginal substitutes for each other so the $/MMBTU
> argument is meaningless. Can anyone name a major consuming sector
> for oil that can easily switch to NG? It's like saying Big Macs and
> carrots should trade at caloric parity.
>
> 2) Oil is priced globally, gas is still largely local. If you pull
> oil out of the ground in Louisiana you could sell it in the UK if
> the transportation economics made sense. That just not possible for
> natural gas. North American Natural Gas is stored and consumed in
> North America. LNG is still a one-way supply line into, but not out
> of, North America.
>
> For a statistical analysis of the WTI/NG relationship, see my instablog.
> We really need to stop obsessing about this non-existent relationship.
The ratio between WTI and nat gas would presumably be due to the relative ease on a BTU basis for drilling for natural gas than oil (long term price=marginal cost), and while shale gas has reduced the price of drilling and the cost of leasing reserves, it hasn't cut it by 2/3s compared to oil. So while the cost should have come down relative to oil due to higher supply and lower demand, the price will have a big impact on natural gas supply, hence the more than halving of the number of nat gas drilling rigs. Supply simply won't hold up under $4 per MMBTU.
Your point might make sense if there was an actual choice for an individual producer whether to devote E&P budget to oil rather than gas, but that's not true in North America. The marginal gas production is in shale plays, which to totally different (geologically, geographically, technically) from oil. In North America, very, very few producers have the technical and financial strength to make the decision, year by year, whether to pursue oil or gas.
You are absolutely correct that NG supply won't hold up at $4.00, but that has nothing to do with the price of oil. If you want to bet NG is going to rise then by all means do so. My point is that there is no good reason to package it with a bet that oil will fall. That is an assessment.
On Jul 09 05:40 PM Daxtatter wrote:
> LOLCapitalist:
> The ratio between WTI and nat gas would presumably be due to the
> relative ease on a BTU basis for drilling for natural gas than oil
> (long term price=marginal cost), and while shale gas has reduced
> the price of drilling and the cost of leasing reserves, it hasn't
> cut it by 2/3s compared to oil. So while the cost should have come
> down relative to oil due to higher supply and lower demand, the price
> will have a big impact on natural gas supply, hence the more than
> halving of the number of nat gas drilling rigs. Supply simply won't
> hold up under $4 per MMBTU.
"It's like saying Big Macs and carrots should trade at caloric parity." That is the wittiest line I have read in the comments section on "Seeking Alpha" since I started reading this site two years ago.
On Jul 09 02:09 PM LOLcapitalist, CFA wrote:
> It never ceases to amaze me the extent to which the WTI/NG ratio
> myth is ingrained in the minds of so many traders. Let me be perfectly
> clear: the prices for North American Natural Gas and Crude Oil in
> North American have absolutely nothing do do with one another except
> to the extent that they are both driven (to some extent but far from
> exclusively) by GDP growth expectations. Here are two significant
> reasons:
>
> 1) They are not marginal substitutes for each other so the $/MMBTU
> argument is meaningless. Can anyone name a major consuming sector
> for oil that can easily switch to NG? It's like saying Big Macs
> and carrots should trade at caloric parity.
>
> 2) Oil is priced globally, gas is still largely local. If you pull
> oil out of the ground in Louisiana you could sell it in the UK if
> the transportation economics made sense. That just not possible for
> natural gas. North American Natural Gas is stored and consumed in
> North America. LNG is still a one-way supply line into, but not out
> of, North America.
>
> For a statistical analysis of the WTI/NG relationship, see my instablog.
> We really need to stop obsessing about this non-existent relationship.
HardToLove
On Jul 08 07:26 PM DaveW wrote:
> "We've recently come to the realization that the US sits on a giant
> natural gas formation."
>
> Is it just me or is the fact that we sit on a methane bubble just
> a little more than ironic in retrospect?
On Jul 10 01:37 PM Maxe Paul wrote:
> Bottom Pickers..................
On Jul 09 07:33 AM prairiedog555 wrote:
> Also, the only game changer that I can see would be if Pres. Obama
> and his Dem handlers do the right thing and begin to push for energy
> independence by promoting Nat Gas for transportation. Just think
> if they did subsidies like what was done for ethanol.
> Why don't they do this? I guess it makes too much sense.
EpiphanyOne
To make a large scale switch, capex would be required, regulatory filings for rate increases, etc. Might take a day or two.
HardToLove
On Jul 10 03:40 PM Jolly_Rancher wrote:
> How easy is it for end users to substitute NG for oil? Impractical
> for individuals/drivers. Manufacturers? Utilities? My guess is, they
> are locked in to one or the other. Hard to subsitute.
>
> On Jul 09 07:33 AM prairiedog555 wrote:
HardToLove
On Jul 10 04:59 PM Ryan Barnes wrote:
> It's worth noting to potential investors in this space that UNG and
> USO use near-term futures as their proxies...the current steepness
> of the more distant contracts (to the front months) could have UNG
> underperforming natural gas if the underlying doesn't move much this
> summer.
>
> EpiphanyOne
Oil does not compete with anything in driving, on the other hand Nat gas competes with coal etc in electric generation and heating oil in heating.
Like someone said on top "we can't compare carrots and Big Macs on calorific value", same logic applies to oil and Nat Gas.
Nat gas supply is ever increasing especially with all kinds of new discoveries, pipelines, LNG vessels and terminals. See further downside to Nat gas, also in Oil - you can't hold up prices by cutting back production and holding back inventories from the market (oil barges) - we have the worst worldwide recession.
On Jul 11 12:37 PM Fighting Yoda wrote:
> Oil and Nat gas comparisons are irrelevant - just because they both
> are petroleum based fuels don't make them similar in any way- they
> have their own end uses and supply/demand dynamics. Nat gas is mostly
> used for heating and electric generation, oil is mostly used for
> driving, they have some overlap in chemicals.
> Oil does not compete with anything in driving, on the other hand
> Nat gas competes with coal etc in electric generation and heating
> oil in heating.
>
> Like someone said on top "we can't compare carrots and Big Macs on
> calorific value", same logic applies to oil and Nat Gas.
>
> Nat gas supply is ever increasing especially with all kinds of new
> discoveries, pipelines, LNG vessels and terminals. See further downside
> to Nat gas, also in Oil - you can't hold up prices by cutting back
> production and holding back inventories from the market (oil barges)
> - we have the worst worldwide recession.
What a factual article. Thanks for the nice update. Keep it up! But aside from that breaking and sizzling report let me impart something new concern to you. Grilling and barbecuing is an institution of American cuisine, and a particular model of charcoal grill is starting to cause quite a stir, called the Big Green Egg. The Big Green Egg is a large shell with vertically stacked grill grates and plenty of internal space, and it doubles as a smoker, in case standard steak or burger fare is just no good and you want slow cooked brisket or ribs. A person can grill ten steaks at once, or bake bread – it might be worth some fast cash to get one. Users swear by the Big Green Egg grill, and it might be worth a payday loan to add it to your grilling arsenal.