16.1 – History and background

I know this chapter on Natural Gas is coming in late; we should have discussed this much earlier, probably when we discussed Crude oil. Unfortunately, I missed doing this; but anyway, better late than never!

We will discuss Natural Gas in this chapter, and with that, we will conclude this module on Currencies and Commodities.

As usual, let us start our discussion with some background information, history, and how natural gas is extracted.

Natural gas is a naturally occurring, non-renewable, hydrocarbon gas mixture, primarily consisting of methane. Natural Gas is a fossil fuel and is used as an energy source. Natural gas has many applications in our day to day lives, including electricity (generation process), heating, and cooking. Besides, natural gas also has a wide variety of application in the fertilizer and plastics industry.

Apparently, way back in 1000, B.C., natural gas seeped from the ground, on Mount Parnassus in ancient Greece, caught fire and a flame was lit.

The Greeks believed this was the Oracle at Delphi, and a temple was built. This has to be the first-ever reference to Natural Gas. By the way, do you wonder how natural gas can seep through the land surface? Well, have a look at this picture of natural gas seeping from the ground and catching fire –

Source: Daily mail online, UK.

The Chinese discovered Natural Gas around 500 B.C., and they put this to better use – they started using bamboo “pipelines” to transport natural gas that seeped to the surface and to use it to boil seawater to get drinkable water.

However, the first commercialized application of natural gas occurred in Great Britain. Around 1785, the British used natural gas produced from coal to lighthouses and streets.

By now, you must have guessed that ‘Natural Gas’ is somewhere hidden deep below the earth’s surface. The question is – how and why is natural gas present there?

Millions of years ago, when plants and animals died, the remains were buried in sand and silt. The buried remains mixed further with sand and silt, got buried deeper, and decayed further. Pressure and heat converted these materials into coal, oil, and natural gas. This entire process panned across millions of years. In some places, natural gas moved into large cracks and spaces between layers of overlying rocks, while in other places natural gas just settled on the porous surface of rocks. Natural Gas, in its original form, is colourless, odourless, and tasteless. Now, practically this can be an issue – imagine if natural gas leaks and spreads, there is no way one can identify its presence in the atmosphere, which is a highly hazardous situation. Hence, producer of natural gas adds a substance called ‘mercaptan’, which gives natural gas a pungent, sulfuric odour, making it easier to detect in case of a leak.

The search for natural gas is quite similar to the search for crude oil. Geologists identify land parcels which are likely to contain natural gas. Sometimes, these land parcels are on the surface of the earth, and sometimes this can be offshore, deep inside, on the ocean floor. Geologists use the seismic surveys to identify the right place to drill to maximize the probability of finding natural gas. If the site seems promising, then an exploratory well is drilled to investigate further. Further, if the economics favour, then more wells are drilled, and the natural gas is extracted from the ground.

India is the 7th largest producer of natural gas in the world, accounting for nearly 2.5% of the natural gas production in the world. The bulk of the natural gas produced in India is used towards power generation, industrial fuel, and LPG. A large chunk is also used in the fertilizer industry as feedstock.

Needless to say, this discussion on Natural Gas – production and application can get quite vast, but I guess we are good to stop here, considering we are looking at Natural gas from a short-term trading approach.

We will move ahead to discuss the contract specification.

However, no discussion on Natural gas is complete without talking about the ‘Amarant Natural Gas gamble’. J

16.2 – Amaranth Natural gas gamble

Amaranth Advisors, established around 2000, was a US-based multi-strategy hedge fund operating from Greenwich, Connecticut. The fund had its interest in various hedge fund strategies ranging from convertible bonds, merger arbitrage, leveraged assets, and energy trading. By mid-2006, the fund had become a $9 Billion behemoth; this included the profits that were ploughed back to the fund. This positioned Amaranth as one of US’s top-performing hedge fund.

Amaranth’s energy trading desk picked up activity (and a lot of attention) when a star trader named Brain Hunter joined Amaranth’s trading team. Hunter had previously gained a lot of popularity for his energy trading strategies (mainly natural gas) at Deutsche Bank. Apparently, he made few millions of dollars as annual bonuses. His success continued when he joined Amaranth to head the energy desk – where he traded natural gas for obvious reasons. Hunter ensured profits rolled for Amaranth and its clients, so much so that Amaranth netted close to $2 Billion by April 2006. Hunter’s trading skills quite seduced both Amaranth’s clients and management.

At this stage, I have to mention this – although an international commodity, natural gas trading was highly vulnerable. Any midsized hedge fund could easily corner the market by taking positions in a few thousands of contracts. This made Amaranth one of the largest hedge funds operating in the natural gas market.

Anyway, here is what happened post-April 2006 –

1. Hunter noticed a surplus inventory of natural gas in the US, which would drive the price of natural gas lower in the US.
2. Inventory of Natural gas, unlike oil, cannot be easily moved to cater to supply-demand pressures.
3. He also expected a harsh winter (or perhaps a hurricane) to ensue, which quite obviously would exert pressure on the supplies and push the price of Natural gas higher.
4. Apparently, Hunter had profited when hurricane Katrina and Rita had hit the US coastlines in 2005
5. He set up complex strategies at multiple points across multiple contracts to benefit from his staggering point of view. These were highly leveraged, speculative futures positions.
6. However, nature had a different game plan for Hunter and Amaranth – the possibilities of a hurricane diminished, supplies continued to pour.
7. Bulls started to unwind, triggering the price of Natural Gas below the psychological support of $5.5
8. This further triggered a panic sell leading to a single day fall of 20% Natural gas’s price.
9. Amaranth was hit quite hard, but Hunter’s conviction and reputation were still intact. They now borrowed money and doubled down on their positions.
10. The leverage was as high as 1 to 8, meaning for every 1 USD of their own capital, they had 8 USD in borrowed capital.
11. This didn’t stop natural gas prices to tank. Further, prices continued to crash, and along with the price Amaranth too crashed.
12. Amaranth was forced to liquidate and take a hit of USD 6 Billion, making it one of the largest hedge fund fiascos in the world.

If there is one key lesson you get to learn from the Amaranth’s episode, then it has to be (yet again) the importance of risk management. Risk management sits above all and has the authority to question every aspect of your trade.

Respect risk and risk respect you back, ignore it, and it will show you the corner.

For this reason, we will dedicate the whole of the next module to Risk and trading psychology.

For now, let us proceed to discuss the contract specs of Natural Gas.

16.3 – Contract specifications

The contact specs for Natural Gas are as below –

• Price Quote – Rupee per Million British Thermal Unit (mmBtu)
• Lot size – 1250 mmBtu
• Tick size – Rs. 0.10
• P&L per tick – Rs. 125/-
• Expiry – 25^th of every month
• Delivery units – 10,000 mmBtu

Here is the snap quote of the Natural gas expiring in Feb 2017 –

The price, as seen here, is Rs. 217.3 per mmBtu. Therefore the contract value would be –

Lot size * price

= 1250 * 217.3

= Rs. 271,625/-

The NRML margin is as shown below –

As you can see, the NRML (for overnight positions) margin is Rs. 40,644/-. This makes it about 15% margin for NRML orders (probably one of the highest in the markets) and MIS margin is Rs.20,322/- which makes it about 7% for MIS positions.

The contract introduction and expiry logic is quite straightforward, have a look at the table below –

Every 4 months, a new contract is introduced. For example, the January 2017 contract was introduced in Oct 2016, and this contract expires on 25th of Jan 2017.

Here is something that you need to know – although, Natural Gas in an international commodity, its spot price in India is also dependent on how the domestic demand and supply situation pans out. However, the futures contract listed on MCX closely mirrors the Natural gas listed on NYMEX.

Have a look at the image below –

This is the graph of the Natural Gas futures contract on MCX overlaid with NYMEX – quite evidently, both the futures contracts move in unison. Given this, the following events have a significant impact on the natural gas prices on NYMEX and therefore MCX natural gas futures –

• Natural Gas inventory data – an increase in inventory tends to lower the futures price and a decrease in inventory data tends to increase the futures price.
• US weather conditions – the US is the biggest natural gas market, so US weather conditions really matter. A harsh winter in the US leads to more natural gas consumption (as people use natural gas to heat homes) and therefore the inventory is consumed rapidly, leading to an increase in price.
• Hurricane in the US – Hurricane besides disrupting the weather conditions also tends to disrupt inventories. Hence, if you see a hurricane approaching the US coast, be prepared to go long in Natural Gas or at least, do not short natural gas contracts.
• The price of Crude oil – Natural gas is not only a cleaner fuel compared to crude but also costs much lower. Historically, the two contracts are highly correlated, although the correlation is not holding up over the recent few months. Check this! 

So, next time you are trading natural gas, make sure to check how the sun is shining in the US!

And with this, folks, we will conclude this chapter on Natural Gas and this module on Currencies and commodities. We hope you liked reading this module as much as we enjoyed writing it for you.

Onwards to Risk and Trading psychology!

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Key takeaways from this chapter 

1. Natural gas occurs naturally and is found deep underground.
2. Natural Gas has been in use since ancient times.
3. The primary use of natural gas includes power generation, heating, cooking etc.,
4. India is the 7th largest natural producer of natural gas.
5. Lot size of natural gas is 1250 MMBtu, price quote if for 100 mmBtu.
6. P&L per tick is Rs.125/- per tick.
7. Natural gas futures on MCX mimic s the price movement of Natural gas on NYMEX.