Currency Market, Commodity Market, and Government Securities

Lesson -> The Natural Gas

16.1 - History, background

This chapter on Natural Gas will be late. We should have discussed it much sooner, probably when we were discussing Crude oil. Unfortunately, I didn't get to do this, but it is better late than never!

This chapter will focus on Natural Gas, and we will end this module on Currencies and Commodities.

Let's start the discussion by giving some background information and history about natural gas extraction.

Natural gas is a non-renewable hydrocarbon gas mixture that occurs naturally. It primarily consists of methane. Natural Gas is a fossil fuel that is used to generate energy. Natural gas is used in many areas of our daily lives, including heating, cooking, electricity generation, and heating. Natural gas can also be used in fertilizer and plastics manufacturing.

It is believed that natural gas from Mount Parnassus in ancient Greece caught fire in 1000 B.C. and ignited.

This was believed to be the Oracle of Delphi by the Greeks, so a temple was constructed. This is the first reference to Natural Gas. Do you ever wonder how natural gas can seep under the earth's surface? Take a look at this image of natural gas leaking from the ground and setting fire to it.

Around 500 B.C., the Chinese discovered Natural Gas. They put it to better use by using bamboo "pipelines", which they used to transport natural gas to the surface. Then they used it to boil seawater for drinking water.

The first commercial application of natural gas was made in Great Britain. The British first used natural gas from coal to power lighthouses and roads in 1785.

You must now have guessed that natural gas is deep beneath the surface of the earth. Now the question is: How and why is natural gas there?

Millions of years ago, animals and plants died and their remains were buried in sand or silt. The remains were buried further in sand and silt and subsequently became deeper and more decaying. These materials were transformed into natural gas, oil, and coal by heat and pressure. The entire process took place over millions of years. Natural gas can be found in large cracks or spaces between layers of rock, while other natural gas is just found on porous rocks. Natural Gas is in its original form is colourless, tasteless, and odourless. This can pose a problem in practice. If natural gas is spread, it is impossible to identify the source. It is highly dangerous. Natural gas producers add a substance called "mercaptan", which gives natural gas a pungent and sulfuric odour. This makes it easier to spot a leak.

Natural gas search is very similar to searching for crude oil. Geologists find land parcels that are likely to be rich in natural gas. These land parcels may be located on the ground, but they can also be found deep below the sea floor. To maximize the chances of discovering natural gas, geologists use seismic surveys. An exploratory well is drilled to explore further if the site looks promising. If the economics favor, additional wells can be drilled to extract natural gas from the ground.

India is the 7th largest global producer of natural gas, producing nearly 2.5% of all world natural gas production. Most of India's natural gas is used for power generation, industrial fuel, or LPG. As feedstock, a large portion of the natural gas produced in India is used by the fertilizer industry.

It is obvious that this discussion about Natural Gas production and application can become quite lengthy, but I think we should stop here considering that we are only looking at Natural Gas from a short-term trading perspective.

We will discuss the contract specifications.

But, Natural gas discussions are incomplete without mentioning the "Amarant Natural Gas Gambit".

16.2 - Amaranth Natural gas gamble

Amaranth Advisors was an American-based multi-strategy hedge funds based in Greenwich, Connecticut. It was established in 2000. It was interested in various hedge-fund strategies, including convertible bonds, merger arbitrage and leveraged assets. The fund was a $9 billion behemoth by mid-2006. This included profits that were returned to the fund. Amaranth was positioned as the top-performing US hedge fund.

Amaranth’s energy trading desk saw a lot more activity and a lot more attention when Brain Hunter, a star trader joined Amaranth’s trading team. Hunter was a popular trader at Deutsche Bank who had been known for his energy trading strategies, mainly natural gas. He was awarded a few million dollars each year in bonuses. He was promoted to the top of Amaranth's energy desk, where he traded natural gases for obvious reasons. Amaranth's clients and Hunter made sure profits were rolled. Amaranth surpassed $2 Billion in April 2006. Hunter's trading skills were a great attraction to both Amaranth clients and management.

At this point, I must mention that natural gas trading, although an international commodity was extremely vulnerable. A few thousand contracts could be enough to make a mid-sized hedge fund dominate the market. Amaranth was one of the most prominent hedge funds in the natural gas market.

Here's what happened after April 2006.

  1. Hunter observed a surplus of natural gas in the US. This would lead to a lower price for natural gas.
  2. Natural gas inventory cannot be moved easily to meet demand pressures, unlike oil.
  3. He also predicted a severe winter or possibly a hurricane to follow, which would put pressure on supplies and drive the price of Natural Gas higher.
  4. Hunter apparently made a profit when Rita and hurricane Katrina struck the US coasts in 2005
  5. To benefit from his unique point of view, he set up complex strategies at multiple points and across multiple contracts. These were highly leveraged, speculative positions in futures.
  6. Hunter and Amaranth were not prepared for the unexpected. While hurricane chances declined, supplies continued to flow.
  7. The bulls began to relax, which triggered the Natural Gas price below the psychological support level of $5.5
  8. This triggered panic selling that resulted in a one-day drop of 20% in Natural gas prices.
  9. Amaranth was severely hurt, but Hunter's reputation and conviction remained intact. They borrowed money and doubled their positions.
  10. They had a leverage of 1 to 8 which meant that for every 1 USD they owned, they had 8 USD borrowed capital.
  11. However, this didn't stop natural gasoline prices from plummeting. Prices crashed further, along with Amaranth's price.
  12. Amaranth had to be liquidated and took a USD 6 billion hit, making it one the biggest hedge fund fiascos.

The Amaranth's episode teaches you one important lesson. It is the importance of risk management. Risk management is the most important aspect of any trade and can be questioned about every aspect.

Accept risk, but also respect the risk. If you ignore it, it will teach you how to turn it around.

We will devote the entire module to trading psychology and risk.

Let's now discuss the specifications of Natural Gas contracts.

16.3 - Contract specifications

Below are the contact details for Natural Gas.

  • Price Quote - The Rupees Per Million British Thermal Unit (mmBtu).
  • Lot Size - 1250 mmBtu
  • Tick size – Rs. 0.10
  • P&L per tick - Rs. 125/-
  • Expiry - 25 the last month
  • Delivery units - 10,000 mmBtu

Here's a quick quote on Natural gas expiring February 2017-

As seen here, the price is Rs. 217.3 per mmBtu. Accordingly, the contract value would be -

Lot size * Price

= 1250 * 217.

=Rs. Rs.

Below is the NRML margin.

As you can see the NRML margin (for overnight positions), isRs. Rs.. This gives a margin of 15% for NRML orders, which is probably one of the highest on the market. MIS margin is approximately 15%.Rs.20.322/-This makes it around 7% for MIS positions.

It is very easy to understand the contract expiry and introduction logic. Take a look at this table.

A new contract is created every 4 months. The January 2017 contract, for example, was introduced in October 2016, and expires on the 25th of January 2017.

This is important information. Although Natural Gas is an international commodity, the spot price of Natural Gas in India is dependent on India's domestic demand and supply. The MCX futures contract closely mirrors that of NYMEX Natural gas.

Take a look at this image -

This graph shows the Natural Gas futures contract on MCX overlayed with NYMEX - it is evident that both futures contracts move in unison. The following events have an impact on natural gas prices on NYMEX, and consequently MCX natural gaz futures.

  • Natural Gas Inventory DataAn increase in inventory tends lower the futures prices, while a decrease of inventory data tends increase them.
  • Weather conditions in the USAThe US is the largest natural gas market. Therefore, US weather conditions are very important. The US experiences a harsh winter, which leads to increased natural gas consumption. Natural gas is used to heat homes. This results in a rapid increase in prices.
  • Hurricane in the USAHurricanes can disrupt inventories and not only disrupt weather conditions but also disrupt inventories. If you see a hurricane coming towards the US coast, it is advisable to be ready to invest in Natural Gas, or at minimum, not short natural gas contracts.
  • The Crude oil price- Natural gas is a cleaner fuel than crude oil and also has lower costs. The two contracts have been closely related historically, but the correlation has not held up in the last few months.

When you trade natural gas, be sure to look at the US's sun exposure!

This concludes the Natural Gas chapter and the module on commodities and currencies. We hope that you enjoyed this module as much we enjoyed creating it.

Moving on to Trading Psychology and Risk Management!

To Summarize

  1. Natural gas occurs naturally and is found underground.
  2. Natural gas has been used since antiquity.
  3. Natural gas is used primarily for power generation, heating, and cooking.
  4. India is 7th largest natural gas producer.
  5. Natural gas lot size is 1250 MMBtu. Price quote for 100 mmBtu.
  6. P&L per tick: Rs.125/- per Tick
  7. The price movement of Natural Gas on NYMEX is mirrored by Natural gas futures on MCX.