Wednesday, August 26, 2009

The Hype about Natural Gas

Apparently the ratio of crude oil to natural gas is at an all-time high, literally. Its perplexing to a lot of people... 100 year events usually are.

For all I know, it may well be some ghastly anomaly. But I can see some rationale for not jumping into the long-natural-gas-short-crude wagon.

To begin with, how exactly do you long natural gas? Do you store it in a cave? You could if you owned one -- you will probably need some insurance though. And you'll need to create a pipeline to your cave. More likely, you would be doing it through one of the ETFs -- which employs some trading vodoo with futures contract. However, I really doubt that the price of natural gas futures and crude futures are really as divergent. Note to self: check before you write.

Now, what if the futures prices are actually that bad? There is stil a possibility that they may not converge. Utilities and natural gas producers can predict what the demand for natural gas will be in December. Barring some extreme weather, it should be pretty pretty easy to predict. And if it is predictable, then futures prices should be reflecting that -- ok, not in theory, because then future price is just a function of interest rate, current price and storage cost.

But what happens when natural gas can not be stored anymore? The relationship above simply breaks down and future price becomes a function of expected demand and supply in the future. There are reasons to believe that this may be the case. According to the chart here.

I actually have a feeling that the price of oil and gas wont converge. In fact, natural gas prices might drop in the winter! The speculators who are entering the market now, buying natural gas futures because they are so cheap, would sell their contracts at a fire sale when they are faced with the prospect of taking delivery of natural gas. :)

Pairs trading works pretty decently, but there is always a peso risk. You cant arbitrage two things that aren't, in essence, convertible. It's not arbitrage, its speculation.

I also have one other explanation for this phenomenon. Since the price of natural gas that everyone is pumped up about is the price of US natural gas, it is entirely possible that this price is suppressed because US's energy demands are suppressed. The price of this gas depends mainly, if not entirely, on domestic demand. However, oil isnt as geographically constrained as natural gas. US demand has an impact on the price of oil surely, but its not the only country affecting the price of oil.

So if the World's demand for energy is growing at a faster rate than that of the United States, it is entirely possible that this divergence would persist for a long time to come -- and in fact, the prices could diverge even further.

Just food for thought.


Upon further discussion with my colleague, I think I should span out this doomsday scenario a bit more.

Apparently, a barrel of oil produces produces 5.8 mmBTU of energy. Natural gas contracts are in mmBTU -- so in a world where energy was just energy, one would expect the price of a oil contract to be 5.5x-6.5x the price of a gas contract. Obviously this is a rather simplistic assumption because oil is easier to store, and requires less of an instrastucture, is used in cars etc. I am just stating the number for the sake of context. Right now, the ratio is closer to 23x -- which is the highest it has been in 100 years. For December delivery the ratio is 15x -- not really as bad, but according to some it is.

Anyway, so here is the doomsday scenario:

Assuming that natural gas is really cheap for December delivery -- everyone who needs it for December would buy enough future contract today to offset their expected requirement in December. Effectively this shuts down the spot market for gas in December because there wont be any buyers. By buyers here, I mean genuine buyers -- entities that will actually use that gas, such as utilities. Might be too much of a sweeping generalisation, but its easier to explain the point.

Now, given that prices are so low, natural gas producers would be inclined to sell more volume to remain profitable. So they keep selling their futures contracts to whoever wants to buy them.

That takes care of the genuine parties. Now there is a group of speculators who want to make money from trading natural gas. Given that natural gas prices are at an all-time low, more speculators are likely to belong to the buying side of the trade than on the selling side of the trade. By speculators, I mean people who are buying futures -- not those who are in the business of storing gas from Summer to December.

In the absence of enough sellers of futures contracts, a significant amount of speculative purchases would lead to increase in prices in the short run. However, if the natural gas producers are selling futures contracts, the price could remain unchanged. Assume that the latter scenario happens.

So we are now left in a market where there is actually a mismatch between real demand and real supply. The speculators have no use for gas, but their counter-parties are gas producers who are willing to settle on their contract by actually delivering gas in December. There are no real buyers as the utilities have enough futures to satisfy their needs.

So, in December, on the on set of the freezing period -- the speculators would be rushing to close their contract. But their wont be many counterparties around. Eventually what may happen is that the natural gas companies would buy back most of these contracts -- but only at prices for which it is profitable for them to not produce.

And the natural gas prices would diverge even further from oil prices.

Not saying that it will happen, or I expect this to happen. Just that it can.

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