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.