Flame On, Natural Gas

Natural gas is having a Marvin Gaye moment: What's going on? For all the attention devoted to gold, natural gas and the already unseasonable winter weather affect my life more directly.

As I explained in a previous column on temperature-related trading in natural gas, the standard measure of heating demand is a heating degree day (HDD), which is calculated by subtracting the day's average temperature from 65 degrees Fahrenheit (65 is the benchmark because when the mercury falls below that level, buildings need to be heated). For example, a 60-degree day is worth 65-60, or 5, HDD. Any day when the average temperature is over 65 is worth zero HDD.

The National Oceanographic and Atmospheric Administration calculates these on a regional basis, and while they are always a week behind in their release, their data for the East North-Central region, where natural gas is the dominant form of space heating, do not show any great surge in cold weather for the period from Nov. 1 to Dec. 2. In fact, the abnormally warm November period, wherein HDD were 59% and 66.3% of normal for the first two weeks of the month, contributed to a climb in eastern natural gas inventories.

Yes, it's cold, but it's supposed to be cold in December -- otherwise I'd have to take the global warming crowd seriously -- but it isn't excessively cold. And inventory levels are just slightly below where they were a year ago, which is remarkable considering that 2.347 billion cubic feet of natural gas in the Gulf of Mexico are still shut-in from hurricane-related damage. That is 23.47% of the pre-hurricane production in the Gulf, a big amount by any measure.

Natural Gas Inventories and Cold Weather

Source: Bloomberg

Supply and Demand Risk

As significant as the hurricane-related production losses are, they have not produced an increase in backwardation in natural gas futures' forward curve. If pipelines and other direct buyers were falling all over themselves to buy more gas for immediate delivery, we should expect to see the January 2006 futures trade well over February. On Friday, January settled under February, $14.312 to $14.391.

Previous late-winter drawdown cycles have resulted in significant backwardation spikes. If the cold weather persists and leads to a late-winter buying panic, buy April 2006 futures and sell May. On Friday, April settled at $11.061 and May settled at $10.731.

We also need to remember that the nature of natural gas demand has changed. The long period of low prices in the 1990s and restrictions on other types of electric utility generation made natural gas a preferred fuel for electric utilities seeking to meet their summer air-conditioning demands. We had relatively cool summers in 2003 and 2004, but 2005 saw much higher natural gas demand by electric utilities. Any fuel buyer must plan to compete with the utilities for summer gas, and that raises the probability of tight supplies going forward into 2006.

Not only are the supply and demand risks high with natural gas, so is its option volatility. Let's take a stock like Google (GOOG - commentary - Cramer's Take), a highflier by all definitions. Its January $410 calls, an at-the-money strike, settled at 33.149% volatility on Friday. The February $14.40 call for natural gas, also an ATM strike, settled at 79.637% volatility. The costs of buying option insurance in this market are extremely high. Whenever someone gasps at the cost of natural gas options, I ask in reply, "Would you write one?" The answer, usually accompanied by a nervous laugh, is invariably no.

Stock Market Response

Let's take a look at a table of industry group performances from April 2004 to December of this year relative to the benchmarks of the large-cap S&P 500, the mid-cap S&P 400 and the small-cap S&P 600 as a function of natural gas prices. The positive numbers in black at the bottom of the table are those groups benefiting from higher natural gas prices. They are, unsurprisingly, concentrated in the oil- and gas-related sectors; more on that later.

The negative numbers in red at the top of the table are those groups hurt by higher natural gas prices. Not only do they include such obvious victims as chemicals, but a very large smattering of consumer finance and consumer discretionary issues. Just as we can say with certainty that retailers such as Wal-Mart (WMT - commentary - Cramer's Take) and Costco (COST - commentary - Cramer's Take) are hurt by higher gasoline prices, we can say with increasing certainty that the money now spent on home heating is coming right out of households' discretionary budgets. This is a macroeconomic impact, one that very well may support bonds at the expense of stocks as the winter progresses.

Natural Gas Stocks Take Off

Prior to February 2004, purchases of the stocks in the Amex Natural Gas Index (XNG) made during a natural gas price spike (green vertical lines) invariably underperformed the broad Russell 3000 Index. It's different this time: The relative performance of the XNG to the Russell 3000 began increasing, and with some prominent exceptions such as October, has remained, regardless of the vagaries of natural gas prices.

The natural gas stock market senses a scarcity premium for natural gas and a huge need for investment. This is the same sense conveyed by gas' price, forward curve and volatility structures. The eventual result given the world's vast gas reserves will be lower prices, but between now and eventually, there are a few bucks to be made.

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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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