Can someone explain how the price gaps on NG work?

[Maverick74]

Partly, that’s true. Partly there is some level of mean reversion present probably and some is filtering through from the oil curve term premium.

But let’s say it is purely a synthetic call option (which it can’t be, since weather might also turn out unseasonably warm). There is nothing wrong with being short that kind of optionality in a reasonable size - at least it’s decorrelated from the equity markets.

The warm weather would "steepen" the contango, not shorten it. Warm weather "increases" the demand for storage. That "term" premium goes up. That is where he gets fucked on the call. During cold weather, you're pulling molecules "out of" storage thereby pushing the curve into a more backwardated structure. The so called term premium comes out. To see this more intuitively just look at HJ (the widowmaker). That is the ultimate risk trade because march is end of storage season (give or take). So march trades at a huge premium to april because of the possibility of running out of storage. That curve is deeply backwardated. A warm winter would suppress that premium. But during winter season it flips.

Warm weather raises the cost of storage because market players don't want to sell into a depressed market. You buy capacity, store it, and wait. That is why storage is a synthetic call. You own the optionality. If the cold weather never comes you eat the storage cost. If we get a polar vortex and natty goes to the moon, you exercise that call and sell into the spike. So your "buddy" wants cold weather to extract that premium, not warm.

 

[Maverick74]

There is nothing wrong with being short that kind of optionality in a reasonable size - at least it’s decorrelated from the equity markets.

But you are 100% correct. It absolutely is decorrelated from the equity markets.

 

[sle]

Very interesting, thanks! I don’t know anything about energy markets beyond snippets of what I overhear from fellow PMs or friends.

Ps. This said, I have to think that this particular friend knows what he’s doing at least a little.

The warm weather would "steepen" the contango, not shorten it. Warm weather "increases" the demand for storage. That "term" premium goes up. That is where he gets fucked on the call. During cold weather, you're pulling molecules "out of" storage thereby pushing the curve into a more backwardated structure. The so called term premium comes out. To see this more intuitively just look at HJ (the widowmaker). That is the ultimate risk trade because march is end of storage season (give or take). So march trades at a huge premium to april because of the possibility of running out of storage. That curve is deeply backwardated. A warm winter would suppress that premium. But during winter season it flips.

Warm weather raises the cost of storage because market players don't want to sell into a depressed market. You buy capacity, store it, and wait. That is why storage is a synthetic call. You own the optionality. If the cold weather never comes you eat the storage cost. If we get a polar vortex and natty goes to the moon, you exercise that call and sell into the spike. So your "buddy" wants cold weather to extract that premium, not warm.

 

[Overnight]

...If we get a polar vortex and natty goes to the moon, you exercise that call and sell into the spike. So your "buddy" wants cold weather to extract that premium, not warm.

And then there is the other ultimate scenario, from that movie "The Day After Tomorrow". (Will not distract the thread with vids here, hehe)...

The thing about this Mav, aside from just weather patterns dictating future price, is also the other variables of the fracking thing going on, and the severe variability in the supply of NG going forward to each season. Plus, NG ain't used for just heating homes, but also for electricity generation.

I've watched NG go down on winter delivery months, because of positive CL numbers around the same time. Like how in August when Harvey hit, RB went through the roof because refineries shut down, so gasoline supplies were disrupted. At the same time, CL tanked because since the refineries shut down the demand for CL went way down.

These variables make me ill. I need a better brain.

 

[nuclearmeltdown]

There is not a gap. Each month is it's own unique physically settled contract. There are strong seasonal differences in various months in natural gas. There is nothing to exploit here. The Nov contract is specifically for that date. If you owned physical storage, you could buy gas for nov delivery, take delivery, inject it into storage and if the cost of storage and transport was < .20, then you could store it and sell that gas into dec delivery. Without such storage there is nothing you can do.

The thing is that the gap varies dramatically, so for example, let's say that Nov/Dec gap in contract was 10 cents about 3 months ago in Sept, and now it is sitting around 20 cents, what causes that price difference to shift rather than remain at a constant value? Presuming the 10 cents between Nov/Dec is the 'premium' that is added on for winter season, why would the premium continue to increase? What other factors outside of the supply/demand/weather picture can cause premiums/gaps to change?

I also see the delta of some months behaving strangely, and not following the equation but that's a question I can save for another time.

Another example I found was the front month Aug trading at a +premium to the April 18 contract. The spread was almost 30 cents, so I shorted the front month and went long April. At this point now, the spread is almost even ~5 cents between December and April, which doesn't "feel" right to me, so I want to understand what is driving this shift?

I feel like winter months like Dec/Jan/Feb should trade at a much higher premium to other months like April-June, so when Dec/April are both priced evenly, I want to understand if it is because the Dec contract is "cheap" or the April contract is "expensive".

Your knowledge of trading far exceeds mine, I was unfamiliar with what a synthetic call was, and had to look it up. XD

I think I was not clear in my original post.... My question was something like: If Dec/Jan usually has a spread of 5-10 cents between them (Where Jan is more expensive than Dec), and the spread either increases significantly, or decreases significantly, what is driving the price shift and how can I exploit it?

The example I used with Nov/Dec where Nov closed at 2.75 and Dec was 2.95 seemed like a good short opportunity for Dec (Or long Nov presuming this gap will normalize) because the spread between the two is usually ~10 cents. Of course, the risk you run is that the spread could continue increasing further and further to something like 40 cents...

 

[Maverick74]

The thing is that the gap varies dramatically, so for example, let's say that Nov/Dec gap in contract was 10 cents about 3 months ago in Sept, and now it is sitting around 20 cents, what causes that price difference to shift rather than remain at a constant value? Presuming the 10 cents between Nov/Dec is the 'premium' that is added on for winter season, why would the premium continue to increase? What other factors outside of the supply/demand/weather picture can cause premiums/gaps to change?

I also see the delta of some months behaving strangely, and not following the equation but that's a question I can save for another time.

Another example I found was the front month Aug trading at a +premium to the April 18 contract. The spread was almost 30 cents, so I shorted the front month and went long April. At this point now, the spread is almost even ~5 cents between December and April, which doesn't "feel" right to me, so I want to understand what is driving this shift?

I feel like winter months like Dec/Jan/Feb should trade at a much higher premium to other months like April-June, so when Dec/April are both priced evenly, I want to understand if it is because the Dec contract is "cheap" or the April contract is "expensive".

Your knowledge of trading far exceeds mine, I was unfamiliar with what a synthetic call was, and had to look it up. XD

I think I was not clear in my original post.... My question was something like: If Dec/Jan usually has a spread of 5-10 cents between them (Where Jan is more expensive than Dec), and the spread either increases significantly, or decreases significantly, what is driving the price shift and how can I exploit it?

The example I used with Nov/Dec where Nov closed at 2.75 and Dec was 2.95 seemed like a good short opportunity for Dec (Or long Nov presuming this gap will normalize) because the spread between the two is usually ~10 cents. Of course, the risk you run is that the spread could continue increasing further and further to something like 40 cents...

Why would the spread be fixed? All months trade based on their own supply and demand conditions. The spread should equal the marginal cost of storage which changes daily. Do you ever buy gasoline for your car? Does the price of gas stay fixed? Of course not. Well neither does any of the input costs. Hell even labor costs don't stay fixed. As demand changes to pull gas out of storage then so does the demand "for" storage. If it's 80 degrees in Chicago in november, I sure as hell don't want to pull natty out of storage to sell into that market knowing in jan it will probably be 10 degrees. So I'm going to bid up the price of storage so I can store my gas today to sell it in the future. That will push the term structure deeper into contango.

I would be very careful about trying to sell expensive months vs cheap months. The price for natty is based on a specific date in the future, at a specific location. The spreads have no reason to converge because there is nothing to converge to. There is no one price for gas. Hell, even today the spot price for gas is different in Boston then it is in southern california.

In order to trade these spreads you really need to do some technical data analysis and build a model that takes into account seasonality, storage, demand (degree days), etc. Simply looking at a spread and saying it's wide and it will converge is NOT the way you want to trade this product.

 

[nuclearmeltdown]

Examining fundamentals has gotten me nowhere hahaha... I tried to collect EIA/NOAA data to chart storage, production, demand, temps, and price against time to see if I could get a general idea of where things should/could be headed and it doesn't seem to correlate in a reliable fashion.. I felt like I was just guessing half the time and flipping coins.

I'm still trying to learn though, and this is all good information. I figure the professional traders using models also have more information than I do, and probably better/more accurate models because of it.

So from your perspective it seems I'm doing nothing other than rolling dice at the casino hoping that I hit red because my methods are a little too crude.

Hmm, now I feel lost. Back to selling option spreads?

 

[Overnight]

Examining fundamentals has gotten me nowhere hahaha... I tried to collect EIA/NOAA data to chart storage, production, demand, temps, and price against time to see if I could get a general idea of where things should/could be headed and it doesn't seem to correlate in a reliable fashion.. I felt like I was just guessing half the time and flipping coins....

Heh, in the spring I tried to take the fundamental route in CL with the folks at

https://www.genscape.com/oil-services#tabs-About-Genscape-Oil-Market-Services_panel

and

https://financial.thomsonreuters.co...eikon-trading-software/commodity-trading.html

Trying to trade strict fundamentals in energies is extremely difficult for people who have just a passing interest in it. One would have to either dedicate their life (and a LOT of money) to it, or be on the inside in the industry, to be good at it I reckon'. (or both!)

It is not something to try half-heartedly with real money. But I find it fascinating. Unfortunately I do not have the time/money to go down that path, but the journey was well worth it, just to know how deeply that rabbit hole goes!

 

[Maverick74]

Examining fundamentals has gotten me nowhere hahaha... I tried to collect EIA/NOAA data to chart storage, production, demand, temps, and price against time to see if I could get a general idea of where things should/could be headed and it doesn't seem to correlate in a reliable fashion.. I felt like I was just guessing half the time and flipping coins.

I'm still trying to learn though, and this is all good information. I figure the professional traders using models also have more information than I do, and probably better/more accurate models because of it.

So from your perspective it seems I'm doing nothing other than rolling dice at the casino hoping that I hit red because my methods are a little too crude.

Hmm, now I feel lost. Back to selling option spreads?

I kind of agree with Overnight. Either go all in and get serious about this stuff or keep it simple. The middle area is very dangerous. Thinking you know something and putting real money behind it is dangerous if you think you are clever.

Try to keep things simple and find a niche and get really good at it. For example, if you really like natty, maybe do some research on the equity names in that space and trade the equities around your views on the commodity. At least if you are wrong you have some options.

If you want to read an outstanding blog on some natty and oil data, this guy is giving a LOT away for free:

http://www.celsiusenergy.net/

If you follow his blog everyday you will start to get a feel for what drives price. But again, either go all in and get serious and take this to a very high level or go the Forest Gump route and approach it very simply. Stay away from the middle. LOL.

 

[nuclearmeltdown]

What's the Forest Gump route? Buy and hold? The simple route might not be a bad plan. I am doing well so far on trading NG, but I feel pretty lost sometimes like recently when the weather model flipped a 180 and I had no idea how to interpret the data...

It does seem like I am in way over my head after talking to you guys XD