Natural Gas: A look at term structureLast week , we examined Natural Gas from a seasonality perspective. This week, we aim to extend that discussion and explore other ways to implement a similar view.
To quickly recap: From a seasonality standpoint, we identified short-term opportunities for a downward move in Natural Gas. Factors such as higher-than-normal storage levels, unseasonably warm weather, and the typical price trends from December to January suggest a potential decline in prices. Additionally, prices have recently broken past initial short-term support, now trading below the $3 handle.
Another perspective worth considering is the term structure. Term structure refers to the difference between futures prices of various maturities of commodity futures. It is visualized by plotting the prices of different expiry contracts, forming what we refer to as the term structure curve.
The term structure reveals other insight that we can explore, starting with the basic slope, which can be categorized as flat, upward sloping, or downward sloping. Understanding these can reveal potential mispricing or provide a clearer picture of market expectations at different future points.
Contango
An upward-sloping term structure, known as "Contango", occurs where contracts closer to expiry are priced cheaper relative to those further from expiry. This can be attributed to factors like storage costs where contracts further from expiry might trade at higher prices due to the associated storage expenses. Sellers, therefore, demand higher prices to offset these costs.
Backwardation
A downward-sloping term structure, termed “Backwardation,” happens when prices in the near months are higher than those further from expiry. This might occur for various reasons such as a benefit to owning the physical material, also known as convenience yield or even just short-term demand pressures.
Term Structure
With a rough idea of contango and backwardation in mind, we can now look at Natural Gas term structure.
The chart above shows the term structure for natural gas 1 year ago, 6 months ago and yesterday.
Here we can see the 3 distinct shapes for the term structure, especially when we focus on the front part of the term structure. With the term structure a year ago deeply in backwardation, 6 months ago in contango and current term structure in a generally flat shape. We also observe that term structure shapes can change quite rapidly hence it can be valuable to look at the shape of the curve to place strategies on the term structure.
For instance, if we maintain a short-term bearish but long-term bullish view, one strategy could be to short the front part of the curve while going long on the back part. This can be achieved by creating a Jan – Jun 2024 calendar spread, going short on the Jan 2024 contract and long on the Jun 2024 contract.
What’s interesting when we look at the Calendar spread vs the outright price moves in the individual leg is that the direction of the outright contract moves generally dictates the direction of the calendar spread. Again, this could happen for a couple of reasons, one being that trading activity often concentrates on the front part of the term structure for liquidity reasons, hence, making the front part of the term structure generally more reactive than the back part of the term structure.
But why trade the calendar spread instead of the outright?
Reduced Margin
Benefits of trading the calendar spread instead of the individual month contract include lowered margin requirements due to margin offsets from CME, reducing the margin needed compared to outright positions.
Reduced sensitivity to risk/black swan events
Both long and short positions in a spread will react together to risk events, albeit to different magnitudes, mitigating overall exposure. For example, during the Natural Gas rally in 2021, while outright prices increased from $2.5 to $9.5, the Jan – Jun 2023 calendar spread only increased by $1 over the same period. Similarly, on the decline, outright prices fell close to $8, but the calendar spread fell by only $0.74. This relatively controlled price swing allows for more manageable risk compared to outright contracts.
Hence to express our short-term bearish but long-term bullish view, we can take a short position on the CME Henry Hub Natural Gas January 2024 Futures and a long position on the CME Henry Hub Natural Gas June 2024 Futures at the current level of 0.11.
The same position can also be expressed using the newly launched (on 6 November 2023) CME Micro Natural Gas. At 1/10 the size of the full-sized contract, the margin requirements to set up a position become more manageable.
Micro Natural Gas Futures Margin Requirements
Alongside the lowered margin requirements, it offers the opportunity to tactically average into a position to achieve a better average entry price for the same amount of capital.
Each 0.001 point move in the full-sized Henry Hub Natural Gas Futures is 10 USD while a move in the Micro Henry Hub Natural Gas Futures is 1 USD.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
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Reference:
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