Natural gas is an extremely volatile futures market. I shouldn’t have to tell you this because I’m sure you see it every day. While most small speculators choose to trade the most populated futures contract in order to lessen the blow of the extreme volatility, most professionals trade spreads.
Those familiar with grain futures know there is an old crop and a new crop. Shrewd traders make a living off the spread between the two crops. In fact, there is a lot of historical data available on this type of relationship between the two crops. Some may argue that “corn is corn”, but just watch the price action between old and new crop corn and you’ll see they are often times driven by different fundamentals. This creates a price spread. It’s not about picking a winner, it’s about predicting the direction of the spread.
The same goes for natural gas. Currently, the October futures contract has the most daily trading volume, but the November futures contract has the most open interest. December natural gas also has large open interest, but January 2021 natural gas has even more open contracts. This is because professionals are trading spreads.
This spread relationship was most evident on Monday when October futures fell sharply, while November and December futures contract prices jumped. The marked difference in the direction of prices was because of the different fundamentals facing the contracts.
Don’t Be Fooled by the Headlines
Some analysts who don’t look at the spreads seem to think that the November and December futures contracts rose because of the new tropical storm in the Gulf of Mexico, but if you took the time to understand natural gas fundamentals and the impact of a hurricane, you would know that this is not the case. If you’re going to trade “cause and effect” then make sure you have the right cause.
October natural gas futures plunged on Monday because of lower liquefied natural gas (LNG) volumes. With the tropical storm threatening an area that produces and ships LNG, a shut down in production is bearish for prices.
Meanwhile, November and December natural gas futures rose sharply because these buyers realize that the LNG production shutdown is a short-term event and that once the tropical storm passes, LNG demand will pick up again. It’s actually been improving since early August.
When trading natural gas, make sure you can reach the same conclusion as the analyst you are reading, using the same tools. Analysts can be wrong especially when they choose to take the easy route. When trading natural gas, make sure you watch the spreads. They’ll tell you more about a market than just reading a weather report and slapping down shoddy analysis.
In my opinion, October natural gas plunged on Monday and closed below the $2.000 level because of poor demand due to the pandemic, cooler temperatures, tropical storm related production shutdowns and worries about storage containment.
Meanwhile, the November and December futures contracts rose sharply because the market expects demand conditions will improve later in the fall.
For a look at all of today’s economic events, check out our economic calendar.