Can I trade Natural Gas as an alternative to Crude Oil?

Market Analysis /
12 Aug 2019

When it comes to trading energy, attention for most in the market will focus on crude oil, but other options do exist. In this Hot Topic we’re going to take a look at trading Natural Gas futures, how the price action differs from oil and what to look for in the months ahead.

As with most commodities, there are a vast range of products for sale, but for this asset, the most commonly traded contract is US Natural Gas Futures. It’s priced in dollars per Metric Million British Thermal Units (MMBtu’s) and trades on the Chicago exchange from 5pm on a Sunday through to 4pm on a Friday local time. 

 

Correlation with crude oil?

There’s a degree of correlation with crude oil prices, driven in part by advances in technology which make it increasingly easy for many consumers to alternate between fuel sources. This article shows that the correlation was particularly apparent before 2008, although some suggest that the reason the relationship broke down just over a decade ago was largely driven by the advent of shale fracking. This has served to dramatically increase natural gas output, especially in the US. 

 Source: Bloomberg

As the chart above shows, this surplus capacity has seen prices reigned in for the last few years. In 2005, the price traded as high as $16/MMBtu, a consequence of hurricane activity shutting down many offshore drilling facilities in the Gulf of Mexico. The 2008 spike was also attributed to bad weather, but aside from that, the key variance seen in pricing is one of spikes in the winter as demand from heating requirements increases, followed by lulls in the summer.

 

Is it always a sure bet to buy low?

There may be a temptation to think that with prices down around the $2.40 level and with $5 having been achieved last winter, that a buy and hold strategy from here could be something of a one way bet - but caution needs to be taken. It’s important to understand that in addition to the traditional concept of drilling for natural gas, it can also be generated as a by-product from other processes such as oil drilling.  That lead to the unusual situation earlier this year of natural gas prices in the Permian basin – essentially the West part of Texas - falling into negative territory. Overcapacity from booming oil production and difficulties in moving the gas out of the area lead to producers paying others to take the gas off their hands. Whether such a situation would ever be seen with the price of the benchmark future is open to debate, but unlike most manufactured goods which come with a physical cost of production, some genres of Natural Gas don’t carry this liability.

 

Political risk?

Much of Europe’s natural gas is currently imported from Russia, with some 37% of all supplies coming from the country last year. There are fears that Europe risks becoming too reliant on getting energy from a nation whose actions have at times put them at odds with the wider global community, but with prices so low thanks to abundant supply, it would seem unlikely that Moscow would look to cut off this valuable source of foreign currency. The USA is also investing in its infrastructure network for gas distribution and although physics dictates that this can be a cumbersome product to transport, liquefaction allows the gas to be condensed into a liquid and transported by ships in much the same way as oil. That bumper production across the Atlantic means the US is soon tipped to be able to account for 40% of European demand alone. In June 2019, Poland committed to buying more natural gas from the US, as it looks to insulate itself from the political risk of being so reliant on Russia as a supplier and as further infrastructure developments are seen, expect more gas to be exported by Washington.

 

What about the environment?

Could this be the driver of gas prices in the future? As noted upthread, oversupply and a lack of storage options has created instances where natural gas has a negative price. To mitigate this, in some areas with lax environmental controls, producers are simply burning off surplus gas, with drillers in the Permian basin reported to be flaring more gas than the entire residential demand of the state of Texas by the end of 2018. That can’t be right and although there’s nothing to suggest the US will change its environmental views under the current President, there can be little sense in maintaining such a liberal approach to pollution. This agenda is arguably worth watching as changes to producer obligations could act as a fundamental driver for lifting natural gas prices from the low levels which have been observed in recent years.

 

Summary

Natural gas has in the past seen higher levels of volatility when compared to crude oil. However, oversupply means that prices have been depressed for some time. There is still evidence of a simple seasonal pattern being observed, but fundamental changes in environmental legislation or storage capacity issues seem to be the most likely factors that will have the ability to spark a significant price reaction.

 

 


The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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