Managing Editor

A Compelling Energy Ratio

Trading options could add a layer of complexity to the trade that some might abhor.

There is an attractive seasonality in the natural gas/crude oil price relationship, but the ratio is not a very reliable indicator. Using energy-equivalent prices paints a more accurate picture (An explanation of this can be found in the Hard Assets Investor article, "Spreading Oil and Natural Gas" at www.hardassetsinvestor...).

The article illustrates a short-term seasonal futures spread ,with good historic reliability, that capitalizes upon this seasonality.

A simple 1:1 version of the spread (long natural gas/short crude oil), lodged on the first business day after the Labor Day holiday, would have cranked out a 35% return on margin by Friday's close.

Winter Heating Oil, Nat. Gas and Crude Oil Preview

The crack spread for spot month crude versus one-month distant products was $9.59 per barrel as of Friday's close, yielding a gross refining margin of 9.02%.

With the decline in crude prices, refining margins have slowed their seasonal decline and actually buoyed from an early August low of 5.78% (crack spread equivalent: $6.92 per barrel).

The crack spread, and other petroleum complex data, are updated every Wednesday in Hard Assets Investors' daily column, "Brad's Desktop." The most recent update is here: www.hardassetsinvestor....

Spreading Oil and Natural Gas: A Post-Labor Day Plan

An update : a 1:1 spread (long natural gas/short crude oil) established on the first trading after the Labor Day holiday would have gained 35% (return on margin) by Friday's close.

Natural Gas/Oil Price Ratio Predicts Price Hikes

A much more modest, and reliable I think, approach might be to look for seasonal trades based upon the crude oil/natural gas price relationship.

A timely example of an oil/gas spread is presented in the HardAssetsIinvestor.co... article, "Spreading Oil and Natural Gas" (www.hardassetsinvestor...).

A one-contract spread (long natural gas/short crude oil) put on after the Labor Day break had gained 35% as of Friday's close.

Time To Consider Oil's Homely Cousin, Natural Gas

Look here at the HardAssetsIinvestor.co... article, "Spreading Oil and Natural Gas" (www.hardassetsinvestor...) for details on the seasonality of the crude oil/natural gas price relationship.

A one-contract spread (long natural gas/short crude oil) put on after the Labor Day break had gained 35% as of Friday's close.

Spreading Oil and Natural Gas: A Post-Labor Day Plan

If you trade oil and natural gas, one long and one short, whether you know it or not, the NYMEX clearinghouse will count the two positions on your broker's book as a spread.

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.

Ethanol Stock as Cheap as an Ear of Corn?

ADM's not a one-trick pony like PEIX. In addition to corn processing, the company engages in agricultural services, including grain handling and storage, and oilseed processing. Ag services brought in less profit because of merchandising slowdowns and oilseed processing margins have narrowed. The poor performerance in these sectors negated any improvement in corn processing margins.

Tracking Crack Spreads

Emthree -

Let me try to clear up the terminology more succinctly. The "crack" in oil traders' parlance refers to the refining (or "cracking") products -- heating oil and gasoline.

When one "buys the crack," he/she is buying the refining output products and selling the crude oil input. Conversely, "selling the crack" means a trader is buying crude oil and selling the prioducts.

The "spread" refers the (usual) premium commanded by the products over the cost of crude oil.

Diagrammed,a crack spread looks like this:

Buy (Long) Sell (Short) Buy (Long)

CL - (HO +RB) = Spread

While the guys and gals on the trading floor may be "selling the crack," they are at the same time "buying the spread." They want the spread--the products' premium--to migrate in a positive direction (to increase) over the life of the trade.

Capice?

Spreading Oil and Natural Gas: A Post-Labor Day Plan

GKM -

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.

Spreading Oil and Natural Gas: A Post-Labor Day Plan

Nab2807 -

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.

Tracking Crack Spreads

Anachronist -

Natural gas isn't a product of oil refining, so its value doesn't figure into refining margins. Propane can be an output of either natural gas or petroleum distillate production. On the refining side, it's a relatively small factor.

The other products you mentioned don't have futures, so can't be readily proxied. Without real-time price discovery, the spreads utilizing them wouldn't reflect current reality.

As you pointed out, the two distillates--heating oil and gasoline--make up most of the refining output. They're the most marketable products, so their prices influence a refiner's bottom line most significantly.

Tracking Crack Spreads

Bobbo -

The crack spread shown uses product contracts one month forward of the crude futures employed, as stated: "To better simulate real-world conditions, use the distillate prices a month out from the crude delivery to allow for a storage, refining and marketing cycle."

Refinery capacity has NOT been all that that high. Refiners are using only 85%-87% of operable capacity in this high-priced oil environment.

Emthree -

Buying the crack or selling the crack depends upon your context. If you're talking about the spread "cheapening," for example, our lexicon demands that you "sell" now to make a profit. When diagramming the trade, however, the sequence would be:

Long CL--Short HO&RB--Long Spread.

Spreading Oil and Natural Gas: A Post-Labor Day Plan

Once again, READ the article.

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.

Spreading Oil and Natural Gas: A Post-Labor Day Plan

Thanks for your 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.

Cheap Silver: Whither the Ratio?

Chux -

Yes, indeed, there was a big run-up in precious metals prices in 1980. The average nominal price for silver that year was $20.98 per ounce. Adjusted to 2008 dollars, that's the equivalent of $56.01.

From that alone, you can tell how far silver's got to go to provide a real return to fellows like Ernie.

As for the S&P 500 index, its real rate of return since 1970 has been 2.8% per annum, more than a full percentage point better than silver's.

Precious metals may indeed offer portfolio benefits, but that's more a diversification artifact than a return enhancement. Put plainly, silver and gold zig when stocks zag. Overall portfolio volatility may be reduced with an allocation to metals, but at a cost.

Siince 1970, though, the reward-to-risk ratio for silver has been 0.19; for S&P 500 stocks, its been 0.58. To allocate capital to silver, you have to decide what other asset class(es) have to be diminished and what effect that diminution will have on expected returns.