Enigma in Natural Gas Market – Is history set to repeat, or Is this time different?

A sharp move in natural-gas-market contracts has caught traders' attention and sparked talk that at least one market participant may have been caught on the wrong side of a trade.

The March-April 2011 spread, a benchmark relationship because it covers the period from winter to spring, has surged as much as 134% this month and 204% since early May (i.e., since Gulf Oil Spill). And we have also seen the spread in the Oct-Nov halved from 45 cents to 19 cents since early May.

NYMEX Natural Gas Prices and Spread

Source: Bloomberg

In a highly unusual move for this time of year, the price of natural gas for delivery March 2011 on Tuesday jumped to 43.3 cents more than the price for delivery in April. The gap, which was just 24.8 cents on last Friday, narrowed slightly to 36.8 cents on Wednesday. Trading volumes in both contracts have spiked.

Gas prices are typically higher in March, the last month of winter, than in April, when spring temperatures limit the demand for natural gas for heating. A trader expecting an unusually cold winter, for example, would bet on a wide spread between March and April gas prices.

The trade is the same bet that brought down Amaranth Advisors LLC, a Greenwich, Conn., hedge fund, in September 2006. Brian Hunter, a Canadian trader at the firm, placed an enormous bet on the spread on the belief that the March contract would be traded at a huge premium over April. But the spread narrowed from $2.5 to 42 cents that fall, costing the firm $6 billion.

This is peculiar behavior, given that supplies are currently building at a comfortable pace, i.e., whatever the knock-on to gas demand from the situation in the Gulf, it will likely not affect this season’ s refills nor next winter’s deliveries. Moreover, Natural gas U.S. inventories has risen to their highest level for this time of year in June since at least 1993, when the government began collecting data

10 Year Seasonal Natural Gas DOE Inventory Storage Data.

Source: Bloomberg

This then begs the question: are other factors impacting the price path of these spreads? After all, once these spreads lock into a trend they stay on trend, regardless of the underlying fundamental picture. Until last week, the March-April 2011 price spread was very thinly traded because long-term weather forecasts are unreliable, and traders typically don't start making bets on winter gas prices until later in the year. However, both of these spreads of currently decoupled from their respective trends. We haven’t seen these particular spreads behave in such a manner since an Amaranth morphed a $9 billion hedge fund into a $3 billion fund in August 2006. In September 2006, when Amaranth had to reverse its trades, the March-April spread tumbled to as low as 42 cents per million Btu from as high as $2.5 in August. At the time, the spread measured the difference between March 2007 and April 2007 prices

The move in the March-April spread probably wasn't caused by a change in weather forecasts or supply predictions, but there can be two reasons:

CASE I: A trader trying to exit a sizable bet on the spread after a bad wager on something else forced the trader to meet margin calls.

CASE II: Major traders may also be anticipating the U.S. moratorium on offshore drilling in the Gulf of Mexico following the Deepwater Horizon rig explosion will cut gas supplies and alternatively, it may be the result of a single speculator taking a larger-than-normal position contrary to the consensus.

MONTHLY VIEW ON COMMODITIES - JUN 2010

Commodities in May had their steepest monthly decline in 18 months, with a key sector index Reuters-Jefferies CRB index finished down 8.3 percent for May -- its biggest monthly decline since Lehman Collapse. Macroeconomic affairs continued to dominate price direction in commodities, while fundamentals played second fiddle. The whole last month passed away in solving Greece’s issue as major economic actions took place by European countries and IMF. Germany's parliament approved a $1 trillion safety net to stabilize the euro as fears swirled that Europe's debt crisis and tougher financial regulation may choke economic recovery.

Euro was poised for a sixth monthly loss against the dollar amid concerns Europe’s efforts to reduce fiscal deficits and stem a sovereign-debt crisis will undermine the region’s recovery. The common currency dropped 7.6 percent in May, the longest monthly losing streak since April 2000. Germany has temporarily banned naked short selling of some securities in the European Union to prevent euro’s gain. Euro is expected to trade in range of 1.15 to 1.25 in the month of June

Crude oil futures posted their worst monthly performance since December 2008 declining more than 15% ended at $74 for May 2010. . Oil prices fell to $65 from $86 in the first half as Euro plunged to near 1.21 against dollar curbing investment from oil to precious metals and dollar. Crude oil futures recovered from lows and managed to trade near $75 in the second half as subsequent moves by EU finance ministers to guarantee liquidity for vulnerable economies restored confidence in the world markets.
The most awaiting hurricane season is at the gate and NOAA- National Weather Service projects ‘active to extremely active’ Atlantic Hurricane Season for 2010. There is a 70% chance that three to seven major hurricanes will swirl in the Atlantic in the six months following the start of the hurricane season on June 1, according to NOAA's Climate Prediction Center. A typical season has 11 named storms, six hurricanes and two major hurricanes. Oil prices are expected to trade higher and may see $87 levels facing very volatile sessions on better economic outlook supported by summer driving demand and speculative trades on Hurricane season with support at $65.

Natural Gas futures rallied more than 10% capping the biggest monthly gain after December 2009 ended at $4.34. Natural gas prices managed upward momentum from the previous month as investors hatched the buying opportunity at $4 on higher demand forecast in summer. Natural gas prices are expected to trade higher on summer cooling demand expectation and supplies and shipment disruption problems in GoM due to BP oil spill backed by intense hurricane season forecast. Growing supplies will limit upside with resistance at $4.70 level, support for falling prices lies at $3.80

Gold-“A mask of Gold hides all deformities.” –The statement proved to be correct in the last month as investor around the world rushed for safe heaven demand against probable expectation that Europe’s debt Crisis may stall the global recovery resulting the bullion to make all time high of US $1250 an ounce. ETF’s around the world bet the most on Gold as many of them made the all time high holdings. SPDR, the biggest Exchange traded Fund backed by bullion has added the skyrocketing 109 Metric Tons on a monthly basis making the all time high of holdings at 1268 Metric Tons. Indian Gold Prices also rallied to record high Rs 18700/ 10 gm, rising 7% during the month of May. This rally was supported by 4% depreciation in India Rupee and 3% price rise in COMEX Gold. The expected Price Range for Gold June Month contract is $1170/oz to $1280/oz.

Silver, basically a precious metal but because of it’s large industrial usage often considered as an industrial metal and hence sometimes guided by the metal prices which is what exactly has happened in the last month. Even after strong China’s CPI as well as positive US industrial data Euro pessimism overshadowed the Silver demand in the expectation of slower global recovery resulting the flat ending with the 0.37% in red trading at $18.56/oz. For the June month, we expect the prices to trade in the range of $17/oz to $21/oz.

Base Metals complex nose-dived in the previous month as the debt concerns overhaul in the market coupled with dollar’s rally and mounting speculation that China’s efforts to cool its economy will erode demand from the largest consuming nation. Base metals prices were dominated by mixed sentiments in the market as positive economic data from US and ongoing European crisis meddled with prices. US economic data showed improvements in housing and consumer confidence but only managed to spark brief strength in the counters. For next month, prices of base metals to remain more or less sideways with negative bias during June. Lead and zinc looks negative on lack of real demand, while copper and nickel could see some buying opportunity at lower levels.

Copper closed at Rs 319 per kg, down near 3% in a month. The decline in LME Copper forwards was more than what we saw in Indian futures. LME three-month forward prices settled at $ 6940 per tonne, down by 7%. Inventories were down in May, declining by 22575 tonnes or 4.5% in LME to 476725 tonnes. One Month expected trading range for LME Copper would be $6000/t-$7400/t.

Lead and Zinc futures declined sharply, as risk-averse investors abandoned the volatile base metals market and headed for safe haven investments such as gold. Lead market fundamentals remain weak, at least over the near term. Stockpiles are rising and there is no sign of decreasing output, or increasing demand. Lead for three month delivery on the LME hit $1721 level and closed at $1850, down 17%. Next Month expected trading range for LME Zinc would be $1700/t-$2200/t and Next Month expected trading range for LME Lead would be $1550/t-$1950/t.

Nickel prices have remained relatively strong during the year however last month was skeptical due to jitters in broader markets. Lower Steel prices and declining confidence of investors have affected the prices of Nickel badly. LME 3-month nickel prices came under pressure on Europe sovereign debt default contagion fears and threats of Chinese monetary tightening. LME nickel prices settled at $21350/t, worst performer on metals counter as down by nearly 19%. Next Month expected trading range for LME Nickel would be $19500/t-$22000/t.