Natural Gas Trading Guide

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Updated: 23 October 2020

Natural gas is a clean-burning fossil fuel that is used throughout the globe. Natural gas is used as a thermal energy source to heat homes, to cook food and generate electricity.

It is also a transportation fuel used in cars, busses, and trucks. Natural gas is found in rock formations that have been buried for millions of years as well as coal bed reservoirs and petroleum pools.

Natural gas is actively traded in both physical and financial formats. This includes a robust futures market, an active over the counter market, ETFs as well as CFDs.

Since it is a gas, most of the movement of natural gas is through pipelines. To ship natural gas overseas it needs to be turned into a liquid known as liquified natural gas (LNG). The US has the largest active natural gas financial market and has a vast pipeline system that crosses north into Canada and south into Mexico.

What is Natural Gas?

Natural gas is a hydrocarbon gas mixture that is mostly methane. It was first discovered by the Chinese in about 500 BC.  It is also what is considered a greenhouse gas that creates carbon dioxide during oxidation.

Natural gas is found in rock formations that are found beneath the earth along with other hydrocarbons such as coal beds and petroleum pools. Additionally, natural gas is found in shale formation and can be released with hydrofracking techniques.

Shale gas is natural gas produced from shale beds requiring permeability that will allow gas to flow in economical quantities. Hydrofracking is the process of shooting a mixture of water and silica sand into the shale, which busts the formations apart releasing natural gas. The water from this process is then considered contaminated and needs to be discarded.

Natural gas is created over time by thermogenic and biogenic processes. Thermogenic natural gas formation occurs deep below the earth's surface where high temperatures and pressure, create natural gas from buried organic material. Biogenic gas is created by methanogenic organisms in marshes, landfills, and shallow sediments.

Most of the impurities that are found in natural gas need to be removed before it can be used as a fuel. This includes by-products of the processing operations including ethane, propane, butanes, as well as carbon dioxide, water vapor, and sometimes helium and nitrogen.

Natural Gas Trading Guide

How is Natural Gas Measured and Priced?

Natural Gas is measured by volume in cubic feet. A cubic foot of gas is the amount of gas needed to fill a volume of one cubic foot under set conditions of pressure and temperature. To measure larger amounts of natural gas, a “therm” is used to denote 100 cubic feet, and “mcf” is used to denote 1,000 cubic feet. A therm will vary by location based on the variance of temperature and pressure. Generally, 1 therm is equal to 100,000 British Thermal Units (BTUs). The pricing on natural gas will generally be in the form of millions or billions of BTUs.

How is Natural Gas Used?

  • Electricity 35%
  • Industrial 33%
  • Residential 17%
  • Commercial 12%
  • Transportation 3%

There are several uses for natural gas. The majority of the natural gas consumed in the United States is for electrical power. According to the US Energy Information Administration (EIA), approximately 35% is used to generate electricity via turbines. Natural gas was the source of about 29% of the U.S. electric power sector's generation capacity.

In the Industrial Sector, natural gas is used for heating, and for power systems, as well as for raw material to produce chemicals, fertilizer, and hydrogen.

Natural gas is used in the residential sector to heat buildings and water, to cook, and to dry clothes. About half of the homes in the United States use natural gas. Natural gas is the source of about 24% of the U.S. residential sector's total energy consumption according to the EIA.

The commercial sector uses natural gas to heat buildings and water, to operate refrigeration and cooling equipment, as well as cooking.

The transportation sector uses natural gas to operate compressors that move natural gas through pipelines. It is also used to fuel cars, buses, and trucks via compressed natural gas and liquefied natural gas. Nearly all vehicles that use natural gas as fuel are in government and private vehicle fleets according to the EIA.

According to the Energy Information Administration 5-states combine to consume 37% of the natural gas supply in the US. This includes Texas at 14.7%, California at 7.1%, Louisiana at 5.8%, Florida at 4.9%, and Pennsylvania at 4.8%.

Natural Gas Demand and Supply

The demand for natural gas will fluctuate based on weather and economic industrial output. During periods of economic contraction, natural gas demand will usually decline. For example, during the COVID-19 quarantine, the total consumption of natural gas is expected to average 81.7 billion cubic feet per day in 2020, down 3.9% from the 2019 average because of lower industrial sector consumption of natural gas.

US natural gas production hit an all-time high 2019, averaging 92.2 Bcf per day according to the EIA. Natural gas production is expected to fall to approximately 85.4 Bcf per day by December 2020. In 2021, natural gas production is expected to average of 84.9 Bcf per day.

Natural gas is exported overseas in the form of liquified natural gas. EIA forecasts that U.S. liquefied natural gas exports will average 5.8 Bcf per day in 2020. US liquefied natural gas exports are expected to decline into 2021 as a result of lower expected global demand for natural gas.

How to Measure the Forecast of Demand and Supply

One of the best ways to measure the forecast of demand and supply is to evaluate the inventory levels that are estimated by the US Department of Energy.

working gas in underground storage compared with the 5-year maximum and minimum

Each week the EIA measures the inventory levels of natural gas that are held in storage facilities around the United States. The EIA provides a chart of historical inventory levels which include the 5-year average as well as the 5-year average range (which include both the high and the low during a specific period).

The period between November and March is the withdrawal season. During this period, natural gas consumption is larger than production, and natural gas stockpiles decline as natural gas is removed from storage. During the period April through October, natural gas demand is lighter than supply which means that stockpiles usually rise.

When inventories are rising above the 5-year average range with an upward trajectory, prices are generally declining. When inventories are falling below the 5-year average range and have a downward sloping trajectory, prices are generally trending higher.

How to Trade Natural Gas

There are several ways that natural gas is traded. Those who produce, store, and supply natural gas to consumers trade natural gas physically. Gas is transported generally through pipelines within the United States. The major production regions are in Texas, Louisiana, and North Dakota. Each location trades at a basis to another location which incorporates the transportation costs to deliver the gas.

Natural Gas Futures Contracts

The benchmark US natural gas contract is traded on the Chicago Mercantile Exchange. Each contract holds 10,000 MMBTU (million of British Thermal Units). Every 0.001 per MMBtu = $10.00 per contract. Monthly contracts are listed for the current year and the next 12 calendar years. The exchange adds monthly contracts for a new calendar year following the termination of trading in the December contract of the current year.

The grade and quality of the Henry Hub Futures contract are the physical delivery of natural Gas meeting the specifications outlined in the FERC-approved tariff of Sabine Pipe Line Company.

The Intercontinental Exchange offers several different natural gas contracts, in the Henry Hub Louisiana area as well as throughout the United States. There are hundreds of contracts that can be traded to speculate on the direction of natural gas in a specific area. The liquidity outside Henry hub begins to decline as most of the speculation occurs in this area. The settlement can differ for each contract. The size is standard, but the specific date that the settlement occurs can vary.

Futures contracts provide the buyer and the seller with leverage. Leverage is accomplished with the use of a margin account. A margin account is a futures account where your broker will allow you to control more value using borrowed money. The margin requirement for natural gas is approximately $2,000 per contract. Each contract is worth $19,000 at the price of $1.90, which means the leverage is 9.5 to 1.

Over the Counter Contracts

You can also look to customize a contract through an over-the-counter transaction. Generally, corporate entities that are producers or consumers of natural-gas will hedge their exposure with their banks or investment banks. Many times a bank will provide a client with credit to hedge their risk to a commodity like natural gas. In these instances, a bank will use a futures exchange to lay off the risk they take on from a corporate hedging position. These products would include swaps and options on natural gas. Over the counter, contracts will also extend to basis locations outside of Henry Hub.

How to Trade Natural Gas

Contracts for Differences (CFDs)

Another type of over-the-counter transaction is a contract for differences (CFDs). These are products offered by CFD brokers, that track the movements of natural gas. The CFD will generally track the movements of CME natural gas. There are many benefits to trading CFDs. This includes using leverage. Leverage for CFDs can reach up to 500 to 1. CFDs on commodities generally have lower levels of leverage power which are usually capped at 20 to 1. CFD brokers are regulated at the country level by a regulatory body.

Exchange-Traded Funds (ETFs)

Another way to trade speculate on the direction of natural gas is to transact using Exchange Traded Funds (ETFs). ETFs are trusts that hold either natural gas futures or the equity of natural gas producers. If you want to speculate on the direction of the commodity, you would purchase or sell ETFs that hold futures contracts. Alternatively, you might consider buying the companies that benefit from higher prices.

Natural Gas Trading Strategies

By using either futures contracts, over-the-counter contracts, CFDs, or ETFs you can develop several different trading strategies. Some traders focus on location arbitrages and trade to purchase natural gas an move it to another location with a higher price to generate revenue. If you are looking to determine the future direction of natural gas prices, you might consider fundamental analysis, technical analysis, and sentiment analysis.

Fundamental Analysis

Fundamental analysis is a focus on supply and demand as well as macro factors that could impact the price of natural gas. For example, when economic growth expands, demand should rise, and the vis-versa. You also might consider focusing on inventories. As inventories decline relative to the 5-year average, prices are likely to climb. When inventories rise relative to the 5-year average, prices are likely to fall.

Additionally, several natural gas traders focus on the weather in the US. Colder than normal or warmer than normal temperatures can drive the price of natural gas. You can track this information using daily reports from the National Oceanic Atmospheric Administration. Additionally, during the Hurricane season, natural gas traders will often follow potential hurricanes that might hit the US and create supply disruptions.

Sentiment Analysis

Natural gas is regulated by the Commodity Futures Trading Commission in the United States. This group every week reports futures positions held by different categories of traders.

Commitments of Traders Report Natural Gas 052020

Many traders look to see if the managed money category which is generally made up of hedge funds are increasing or decreasing positions (green circle). They also try to determine sentiment as a contrarian indicator. As of May 26, 2020, the open interest long was not too far from open-interest that is short (red square). When long open interest is much greater than short open interest, hedge funds are too bullish and the price could decline.

Technical Analysis

Another form of analysis is called technical analysis which is the study of past price movements. This could include trend following, momentum analysis, and mean reversion analysis.

The Bottom Line

You might also consider using a combination of fundamental analysis, technical analysis, and sentiment analysis to determine future price changes. Regardless of the strategy you choose, you should remember that natural gas is still a local product. While natural gas trades globally, most of the liquidity is found in the US. Several different futures contracts track the natural gas market, but you can also consider using other instruments including OTC-contracts, CFDs, and ETFs.

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