Spreading Oil and Natural Gas: A Post-Labor Day Plan 20 comments
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By Brad Zigler
For workaday stiffs like me, Labor Day picnics and barbecues are a coda for the lazy, hazy days season and signal the approach of cooler weather and heating bills. Lest that thought put a chill into your holiday plans, let me offer a trade idea with wallet-warming potential.
A recent Wall Street Journal article reported that natural gas prices are cheap relative to crude oil. The article's expert sources claim, in fact, that natural gas futures are trading at some of the steepest discounts seen in several years.
Now, it's not easy to judge the relative value of these fuels due to their pricing conventions. Oil is priced in dollars per barrel, while natural gas is denominated in dollars per million British thermal units (mmBTU). One way to rationalize prices is to reduce crude's value to its energy equivalence. One barrel of crude, on average, supplies 5.8 mmBTU. Divide crude's price by 5.8 and you'll see its thermal energy value.
Energy Equivalence
As an example, NYMEX spot crude closed at $115.29 per barrel on August 28. The contract's energy- equivalent price was $19.88 per mmBTU. Meanwhile, the nearby natural gas contract settled at $8.05 per mmBTU, the energy equivalence of crude at $46.69 per barrel. From this perspective, natural gas is selling for 41% the price of oil.
According to the expert quoted in the Wall Street Journal piece, the gas discount, given current supplies, ought to be at the 60-70% level. The Journal cites new production technologies increasing the pace at which gas can get to market while demand growth slows. All of that, it seems, has widened the discount.
Naturally, there are times when natural gas provides BTUs cheaper than crude and, at other times, at a higher cost. Since 1994, crude has traded at a premium as large as $13.11 per mmBTU, or $76.04 per barrel-equivalent, to a discount of $5.41 per mmBTU ($31.40 per barrel-equivalent).
Going into the fall, crude oil typically commands an energy-weighted premium over natural gas, but that usually wanes as winter approaches. In other words, natural gas prices tend to approach - and sometimes, surpass, those of crude oil in the cold weather season.
Crude Oil/Natural Gas Spread ($ per mmBTU)
Intuitively, that makes sense. After all, gas demand tends to be highest in winter and while refiners' demand for crude diminishes. Annual maintenance programs usually shutter refineries in the winter. Increased gas demand keeps price firm while a slack market for crude allows prices to languish.
We've discussed petroleum market seasonality in several Hard Assets Investors articles, including "Time For Crack Spreads?". Speculators typically buy the spread (long crude oil/short refined products) on Hallowe'en and hold the position until mid-December.
Seasonal Contraction
The most reliable seasonal tendency in the crude oil/natural gas spread is the contraction between September and December. Buying natural gas futures on the first business day of September, against the short sale of crude oil futures, and holding the position until the second Monday in December would have produced gains, on an energy-equivalent basis, in 11 of the past 14 years. The gains realized from the spread have outpaced losses by a 3.4-to-1 margin.
To trade the spread on an energy-equivalent basis, 58 natural gas contracts would have to be purchased for every 10 crude oil futures sold short. Unfortunately, most retail investors find it difficult to trade futures in the size required for energy equivalency and so must content themselves with trading the spread at parity, or one contract per side. Doing so brings down the win/loss ratio to a still-respectable 9-to-5, and lowers the profit ratio to 1.3-to-1. 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.
Long Natural Gas/Short Crude Oil Seasonal Trade (1994-2007)
Looking at the finer-grain detail, natural gas has been the more reliable leg of the spread, winning 79% of the time, versus a winning percentage of only 64% for crude.
| Long Natural Gas | Short Crude Oil | 1:1 Spread |
Average Profit | $13,368 | $1,236 | $14,604 |
Win/Loss Ratio | 11:3 | 9:5 | 11:3 |
Average Win | $16,100 | $3,290 | $17,760 |
Average Loss | $3,000 | $2,620 | $4,310 |
For those investors without the means or desire to trade futures or spreads, then, a reasonable proxy might be the purchase of the United States Natural Gas Fund (AMEX: UNG), an exchange-traded fund that tracks NYMEX natural gas futures. UNG was launched in February this year and trades an average 5.6 million shares a day.
United States Natural Gas Fund (UNG)
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This article has 20 comments:
Dave W -
Indeed, the copy got turned 'round. UNG is the proper trading ticker for the United States Oil Fund and its average daily volume is actually 5.6 million shares.
I didn't leave off the second half of my suggestion. Note that I offered the long ETF trade as an alternative for those who don't trade futures OR SPREADS.
As you can see from GKM's and BigAl45's remarks, not everyone is enamored of spread trading.
That said, GKM and BigAl45, there are distinct advantages to spread trading.
First of all, you're NOT taking on three risks in the trade. You're actually taking on only ONE: the spread itself. With the spread, you really don't care about the general direction of prices, as long as the spread moves favorably. The spread can improve for you in either bull or bear markets. In an outright position, you have to correctly forecast the price trajectory. The risk associated with a spread forecast is smaller and more manageable than the risk of forecasting the outright market direction.
It's not correlation we're looking for in this spread;. it's convergence. You want the discount to shrink over the 3 1/2-month life of the spread.
So far, it's been a pretty reliable bet.
The real trade have nothing to do with any kind of spread/discount just ask Amaranth Advisors how they lost 13$ billion trading NG with most complicated algorythmic software,ask T Boone Pickens if he is bullish on NG now,he will punch you i the face and send you one way to hell,ask Sem Group LP that lost more than 10$ billion on Oil/NatGas futures and options plus OTC (I hate otc) if they are bullish on CL/NG they will through you out of the window of their skyscraper office.
Bottom line reality check:
NG is really cheap if one believes Oil at 115$ is cheap,NG is expensive if one believes Oil is heading for 100,90,85,70,65,55? next year.
You decide what is cheap what is expensive,I sold NG October at 8.10$ and sold put 8.00$ October against it for total profit I can make in 30 days 7600$.I did it on the news Gustav is going to crash all the platforms in the Gulf of Mexico and beyond it.
Maybe I am crazy,maybe not,time will show.
It shows that you only read the 1st 30-40 words of this piece. The whole point of this trade is that he is not taking a directional bet on NG prices but on the spread between NG and crude. You would actually be making money if crude fell to 55 as long as NG does not fall by as much! This is a relative trade so you don't care about the direction of movements as long as the spread narrows.
My only concern is that in the 1:1 spread introduces an element of directional betting on the movement of the more expensive contract i.e. in this case the downward direction of crude.
The energy equivalent trade is in effect the safer bet.
The trade's NOT a long-term prediction for the petroleum complex, it merely capitalizes upon the observed seasonality of the CL/NG price relationship for a 3 1/2-month period.
It's THAT and nothng more; nothing less.
Professional traders make speculations always with an eye to risk-to-reward parameters. The odds of a favorable outcome are a lot higher with the short-term spread than those of a long-horizon outright price forecast. Remember, the longer a trade's time frame, the more mischief unanticipated events can wreak.
Here's the spread's track record, reduced to dollars per barrel-equivalent of oil:
1994 2.39
1995 2.01
1996 6.23
1997 -1.34
1998 3.4
1999 -4.71
2000 31.7
2001 10.81
2002 7.7
2003 10.43
2004 15.75
2005 26.08
2006 16.96
2007 -4.64
That's an average seasonal gain of $8.77 per barrel-equivalent over bull AND bear markets, in environments characterized by gas trading between $1.32/mmBTU and $15.38/mmBTU, where oil sold for as much as $145.29/bbl and as little as $10.72/bbl.
There's less drawdown risk in the spread than an outright play on crude or gas as well.
You're right about trading the spread at parity. As pointed out in the article, the trade's efficiency is reduced, but what's a retail trader to do?
To obtain energy equivalency, you'd have to buy six gas contracts for every crude oil future sold short. That's a little rich for most traders' blood.
NYMEX, too, only grants margin credits for 1-to-1 spreads, so the cost of trading the "tail" of an energy-equivalent spread are very high.
Perhaps this will help you understand. You want to play the spread because you believe there to be a correlation of say 80%. I would play the two legs because there isn't 100% correlation. That way if I'm wrong about one there is a greater chance I'm right about the other. I can cut the loser and let the winner run. I think if you check the probabilities behind this and marry it with the risk/reward with appropriate stop/loss parameters, my strategy will win every time and by a large margin.
You'll probably say that there is no difference and if so then I can't help you. However, I would encourage you to ask Dennis Gartman how spreading oil and nat gas has worked out for him.
The risk at the moment is that in the short term NG prices are likely to fall given the discovery of natural gas shale in the US.
I anticipate the spread to widen before narrowing as automakers and industrials adjust to natural gas use in place of crude.
Read my posts again. I said this is NOT a correlation play; it's a CONVERGENCE trade. And it's seasonal, not secular.
The price relationship between oil and gas isn't static; it moves, at times, with fairly predictable cyclicality.
The reason for the spread? Each of these commodities can be substituted for the other. That's why NYMEX grants spread margin treatment to trades like this. There is, to my knowledge at least, no energy equivalency that can be posited between apples and natural gas.
Spread margins are lower, per unit of risk, than outright margins, affording the spread trader more highly levered profit potential. And THAT preserves capital. As a trader, you'd want to preserve capital, wouldn't you?
You say, " if you check the probabilities behind [the GKM trading strategy] and marry it with the risk/reward with appropriate stop/loss parameters, my strategy will win every time and by a large margin."
How about this? Why don't YOU do the statistical heavy lifting to make your case? I've presented the data for my contention. The burden of proof is on YOU to bolster your position.
Nab -
Shale's presence is already discounted by market. The shifts your talking about are secular and not likely to be felt in the next quarter.
Excellent analysis! I also wrote about the NG/Oil spread this week at
tradesystemguru.com/co...
Steve Moore in his excellent reference The Encyclopedia of Commodity and Financial Spreads (Wiley 2006) ( ca.wiley.com/WileyCDA/... ) notes that a strategy to buy Nov natural gas calls and sell Oct NG calls on Aug 29 and exit Sept 14 has a 100% win ratio over the last 15 years... Nothing to sneeze at.
Convergence without correlation is not possible for your purposes. Anything can converge against anything but you want there to be a reason (for which you have stated the substitutability of the two energy sources - as evidence by historical trends?) otherwise the spread is arbitrary. You must have negative correlation for your trade to work. I can't speak to spread margins but preservation of capital is imperative, I want trades that also give me more opportunity for success within my risk/reward parameters. If I trade oil and nat gas at the same time but separately, correlation is not at all necessary and in fact the lesser the correlation the better chance of success - as in modern portfolio theory.
In any event, best of luck with your strategy.
The reason for variances in the spread, again, relate to the energy equivalence of crude oil and natural gas. Power plants, for example, can be designed to run on oil or gas. The decision to opt for one fuel over another will be made by engineers based upon the prevailing and projected cost per unit of energy.
To say "convergence without correlation is not possible" is nonsense. Correlation measures directionality, yet the spread can improve for the trader whether the two commodities move in concert or in disparity with one another, as long as the DEGREE of movement is favorable.
Once again, it's a SEASONAL trade with a duration of only 3 1/2 months, not a long-term position.