The Volatility of Natural Gas

My focus is mainly in the precious metal sector for the last several years. But I have also been bullish on natural gas for a while. Natural gas is a very volatile market, possibly more so than any others such as oil or metals. But from long term perspective, it correlates closely with oil, since a BTU of energy at the end of the day, is a BTU, and it doesn't matter too much whether it is coming from oil or natural gas or other forms. But from time to time, it can deviate substantially from oil. Like right now, if we look a multiple year gas/oil ratio chart that gas/oil is at the bottom of the trading range today.

Talking about natural gas, everyone would still remember the Amaranth debacle in 2006 and the trader who caused it, Brian Hunter. In 2005, gas had a major up leg, running from $5 to $15, and of course, Amaranth and especially Mr. hunter had made a lot of money. Then natural gas had gone through a correction phase like today. The problem with Amaranth is that Brian kept betting the continuation of this up trend, and worse, with extreme high leverage when the market was against him. What Brian had done was using spread of gas futures with different maturities by buying futures with longer maturity dates and shorting futures with dates closer to maturity. This is basically adding leverage on top of leverage, or using derivative on top of another derivative.

Then other traders smelled blood when rumors circled around that Amaranth had suffered huge losses while the gas market was going the other way (down). They dumped their long positions and shorted the natural gas market to drive the market even lower, and to drive Amaranth out of business. Eventually they had successfully driven the natural gas below $5. This $5 price is merely a market aberration due to the special situation with Amaranth. At that time, I fully expected the natural gas market would recover. Had Brian not used so much leverage, had Amaranth been able to raise more capital and liquidity to hold on to their long positions to avoid margin calls and liquidation, they would have not only survived but also made money at the end, when NG market had recovered and gone through another impressive up leg reaching $13.37 on July 4, 2008, more than double the $6.15 at the same time last year.

The current free fall in the NG market is more in sympathy with the falling oil. This drop may not go too far below the current $9 level, probably $8 - $8.5 range should provide a good support, absent from another Amaranth event. The current drop of NG provides a good buying opportunity for investors with a long term horizon, if they believe that the long term trend on the oil market is intact and only under correction, and oil will stay at 3 digits and go back up to higher high in the future. The historical oil/gas ratio fluctuates between 4-12, with average about 7. Based on this, even if oil is at $100, I wouldn't surprise to see NG go back to $15 next year, with average price above $10 in future years.

A S&P equity analyst wrote at their most recent report: "LNG goes where the money is. With increased international competition, the United States is being outbid for LNG imports. This would imply the United States is going to be more dependent on domestic natural gas production, a trend we see helping to drive up natural gas prices in the United States". What they forgot to mention is Canadian gas companies too besides domestic US ones.

In the next few days here, I will introduce a junior Canadian company for the natural gas play.

Comments

[billp37:]

Natural gas production has apparently decreased since 2001 in the US according to the EIA and dave hughes.

www.prosefights.org/pn...

Where gas prices go may be manipluated?

2008 Jul 30 07:15 PM

[MiningOilGa...:]

I agree that Natural Gas has been volatile in the past, however it seems like NG in the long run can be a very safe place to make an investment. It is quickly becoming a preferred energy resource. Lets just hope manipulation is kept under control.

2008 Jul 31 06:03 PM

[oiler1930:]

I purchase natural gas under forward contracts based on futures prices at the time of purchase. When there occur reasonable dips, I try to enter a portion of needs for contract, and currently am buying out to 2010 needs. In essence, this is a hedging program. The big spike to $15 was aggravated by Amaranth's action, but was impelled by the damages due to Hurricanes Katrina and Rita. It took a while for prices to recede.

My daily analysis is directed to the ratio of the prices of crude, heating oil, and gasoline to the price of natural gas for the three nearby contracts, but corrected to price the cost of the relative heat content of these fuels, the upshot is that natural gas is priced in a range of 47% to 53% of the fuels, prices. This ratio was reversed to about 129% during the panic. Looking only at the record highs, the liquids are about 120% of NG.

Natural gas heat is relatively cheaper because production costs are much lower, and so are gathering and transportation costs. Coal bed methane is now being produced, and is profitable despite somewhat higher extraction costs, including coproduced water.

NG is definitely a cleaner fuel, in part because it is mostly burned at atmospheric pressure. Internal combustion engines, reciprocating or turbine, operate at high enough temperatures that nitrogen oxides invariably are produced as co-products of the combustion. The NOx concentration is not high enough to cause direct toxic symptoms, but is a needed component for the production of ozone during daylight hours. Should our transportation fleets move to the use of NG as a fuel, air pollution will continue to be about what is now.

As an aside, T Boone Pickens hs been touting NG prices in parity with liquid fuels. This would imply a doubling of the price. Such an occurrence would impel a counterattack of increased NG production and distribution, so that demand would be brought to parity with supply, and prices revert to current levels.

2008 Jul 31 10:32 PM