Why Pros Spread Oil and Gas

By Brad Zigler

If there was ever an object lesson of the advantages of spread trading, Wednesday's action in the petroleum markets would be it.

Crude oil prices plunged 4% in NYMEX trading Wednesday after a larger-than-expected build in domestic fuel supplies was reported by the U.S. Energy Department. At the same time, natural gas prices rose by nearly the same amount in anticipation of this morning's storage report.

We've examined the relationship of crude oil and natural gas in previous columns, including "What (Or When) Is Up With Natural Gas?". There's a definite seasonal tendency for crude oil to lose ground to natural gas in the fall and early winter. This tendency has been so reliable over the past decade-and-a-half that professional traders bookmark the deal. Simply put, the pros like the reward-to-risk ratio so much, they make it a regular part of their trading regimen each year.

Spreads, unfortunately, are often overlooked by individual investors. For some, such trades seem boring or overly complex. Others simply don't know that the trade can be done.

So here's the deal: You trade a spread to capitalize upon a change in the price relationship between two or more futures contracts. With a spread, you're not really concerned if one contract moves up or the other down so much as whether the relationship between the two commodities strengthens or weakens.

Let's look at crude oil and natural gas as an example. Since Labor Day, January NYMEX crude has fallen by 4.8%. A short outright position taken in a 1,000-barrel contract at the exchange's minimum margin of $5,400 would have produced a 64.4% return to date. Not bad.

While oil was slipping, natural gas prices for January delivery climbed 16.6%. An outright long position, secured with a performance bond of $5,400, would have yielded a 150.2% return on margin to date. Very not-too-bad.

Now, it's neither been straight up or straight down for these two commodities over the past couple of weeks. The annualized volatility (risk) for the crude oil contract has been 44.3%; for natural gas futures, it's 61.9%.

Imagine now having both positions in account. Combining a short oil position with a long exposure to natural gas entitles you to a 40% margin credit on each contract, granted by the NYMEX clearinghouse. That means you'd put up only $6,480 for the contract pair.

The post-Labor Day return on margin generated by the spread has been 178.9%, but the volatility's been a relatively mild 47.2%. That said, let's recap the reward-to-risk propositions:

	Return On Margin	Volatility (Risk)	Reward-To- Risk Ratio
Long NG	150.2%	61.9%	2.43
Short CL	64.4%	44.3%	1.45
Spread	178.9%	47.2%	3.79

You should now see why the pros like spreads so much. In trading, it's not always about gains; it's more often about how much risk must be endured to garner them.

*Note: The monetary inflation rate is calculated daily and represents the change in our proprietary index since this date one year ago. We update long-term inflation in real time as well. Since 1999, the compound annual growth rate in our index is 5.1%.

Comments

[Aricool:]

this is a lame article because you waited until Nat Gas got a technical rebound after Labor Day to publish it. If you would have published this article any time this year before Labor Day you would have looked like an idiot within two weeks. That rebound in NG had nothing to do with the stupid oil/gas ratio, but was just a matter of OFO's getting annually lifted on Labor Day, which kept the Henry Hub spot price from heading towards $1. Same thing with oil, it is going down b/c distillates have been piling up all year and are maxing out storage- crack spread going towards zero. So speculators and oil market manipulators cannot overcome such blatant evidence of collapsed demand so they bug out, maybe quicker because its a soft time of the year, but nothing special about the oil/gas ratio none-the-less. This article is completely hog wash and opportunistic to look smart about a stupid oil/gas ratio that the traders always love for some reason!

Ari-

Sep 26 10:42 PM

[Brad Zigler:]

Perhaps you failed to note the embedded link to the foundation article, "What (or When) is Up with Natural Gas?" (www.hardassetsinvestor...) which laid out the historical basis for the natural gas/crude oil spread.

That article, published on JULY 8 while natural gas was still cycling lower, cautioned investors that buoyancy shouldn't be expected in gas prices until Labor Day. As it turned out, the market nadir was Friday, September 4 (Labor Day was Monday September 7).

You state: "That rebound in NG had nothing to do with the stupid oil/gas ratio ..."

The oil/gas ratio is a manifestation of the underlying markets' fundamentals; It's an EFFECT, not a cause. No one, in the above article, the linked foundation piece, or in the articles published last year about the spread (starting with "Spreading Oil and Gas," www.hardassetsinvestor..., from August 2008) claimed the ratio was driving market fundamentals.

It's perfectly appropriate to trade seasonal spreads to capture market tendencies. It's been done for years in the agricultural markets and now it's done in the energy complex as well. Spread traders simply note marketthese tendencies and attempt to trade WITH them; ratio plays aren't a causative force themselves.

Even NYMEX recognizes the connection between natural gas and crude oil. That's why the clearinghouse grants margin credits for the NG/CL spread.

Aricool wrote:

> this is a lame article because you waited until Nat Gas got a technical
> rebound after Labor Day to publish it. If you would have published
> this article any time this year before Labor Day you would have looked
> like an idiot within two weeks. That rebound in NG had nothing to
> do with the stupid oil/gas ratio, but was just a matter of OFO's
> getting annually lifted on Labor Day, which kept the Henry Hub spot
> price from heading towards $1. Same thing with oil, it is going down
> b/c distillates have been piling up all year and are maxing out storage-
> crack spread going towards zero. So speculators and oil market manipulators
> cannot overcome such blatant evidence of collapsed demand so they
> bug out, maybe quicker because its a soft time of the year, but nothing
> special about the oil/gas ratio none-the-less. This article is completely
> hog wash and opportunistic to look smart about a stupid oil/gas ratio
> that the traders always love for some reason!
>
> Ari-

Sep 27 07:58 AM

[Ron2008:]

Brad, in your article "What (Or When) Is Up With Natural Gas?" you never said what contracts (month) you were using to play the long NG and short CL spread. Which ones did you use?

Sep 28 08:06 PM

[Brad Zigler:]

January contracts for both commodities.


On Sep 28 08:06 PM Ron2008 wrote:

> Brad, in your article "What (Or When) Is Up With Natural Gas?" you
> never said what contracts (month) you were using to play the long
> NG and short CL spread. Which ones did you use?

Sep 28 10:01 PM

[Ron2008:]

Then why do my numbers not match yours?

On Sep 1, 2005, Jan 2006 NG was 12.467. Jan 2006 Crude oil was 70.41.
On Dec 12,2005, Jan 2006 NG was 14.841. Jan 2006 Crude oil was 61.30.

That's a profit of $32,850. Your chart shows a less than $10,000 profit in the 2005 column.

For the Jan 2007 contracts on the 2006 bar on your chart you show about a $10,000 gain. I show a $19,610 loss.


On Sep 28 10:01 PM Brad Zigler wrote:

> January contracts for both commodities.

Sep 28 11:53 PM

[Brad Zigler:]

Historic figures arise from spot prices. To avoid the roll effect, though, retail traders ought to employ the January contracts in a "spread-and-hold" position. Forward contracts, too, qualify for a lower margin tier.

Sep 29 10:00 AM

[Ron2008:]

You didn't use the Jan contracts to do your chart? Then what good is it?


On Sep 29 10:00 AM Brad Zigler wrote:

> Historic figures arise from spot prices. To avoid the roll effect,
> though, retail traders ought to employ the January contracts in a
> "spread-and-hold" position. Forward contracts, too, qualify for a
> lower margin tier.

Sep 29 12:24 PM