Get Cooking With Gas

You shouldn't kick something when it's down, we're told, but that's foolish advice for traders and investors. Our mission, which we've chosen to accept, is to find the path of least resistance in a market and to fight on the winning side. This difficult task, which violates our sense of sportsmanship and fair play, may be a hallmark of civilization, but it also helps explain why few traders feel comfortable letting their profits run.

The natural gas market of 2000-01 exhibited no such sense of fair play. It kicked the economy when it was down. Along with the unwinding of the technology bubble and the Federal Reserve's excessive tightness in the period, the quadrupling of natural gas prices in 2000 was a major contributor to the poor economy and stock market of 2000-01.

Now that natural gas prices have returned to the lower end of their 1991-99 trading range, on the order of $2.25 per million BTU, should we assume that we'll be free, this winter at least, from price and supply shocks? In a word, no. The forward curve of natural gas futures is signaling a great deal of anxiety about the market's course. More importantly, the curve's shape is raising hedging costs for natural gas consumers.

Unless you happen to be a net producer of natural gas, the affected group includes you.

Forward Curves

The relationship between different delivery months of a physical commodity contains information on price expectations. If the market were trading in "full carry," each succeeding month would be higher than the one before it by the physical and financial costs of storage. This is the way both stock index and bond futures trade, and the way we should expect the upcoming single-stock futures to trade.

Physical commodity markets are affected by capacity constraints on production, transportation and storage, and they are buffeted by seasonal fluctuations. As a result, they seldom trade in the classic full-carry situation. Natural gas, in particular, almost never trades in a full carry. A snapshot of its forward curve from Oct. 12 shows how uneven and unusual this curve is.

Natural Gas Forward Curve From Oct. 12, 2001, to July 2004

Source: Bloomberg

How should we read this curve? The first feature to stand out is the winter price peaks. Nothing unusual here -- we should expect natural gas demand to rise during the winter. But the expected secondary price peaks for the summer months are conspicuous in their absence. These peaks have become an increasingly important aspect of the natural gas market in recent years as more and more electricity generation is fueled by natural gas. The absence of these summer peaks from the curve suggests either that electric utilities are carrying excessive risk or that natural gas supplies are going to be more than ample each and every summer.

If the supply picture were that rosy, however, we wouldn't see either the gradually higher price trend over time or the winter peaks. The conclusion? Our electric utilities aren't as hedged as they should be, and they're planning to pass any higher fuel costs onto you, the consumer.

Another standout on the chart is the rather abrupt price increase between November 2001 and February 2002. This sort of curve, called a contango (no emails asking me the origin of this goofy word, please!), develops when current supplies are seen as abundant and prices are low, but future prices are seen as rising. Contango curves make life expensive for natural gas buyers who wish to hedge. Not only do they have to pay all of the costs of carry, but they also have to pay a premium reflecting the expectation of rising prices.

How expensive is this premium, you ask? Well, if the natural gas forward curve was in full carry, we should expect January 2002 to be trading near $2.54 instead of $2.91. If we annualize this difference from the November price of $2.43, as illustrated below, we get a hedge cost of 127%. That's enough to make your hand shake while pulling out the checkbook, and these high hedge costs definitely discourage active risk management by natural gas buyers.

Investing Implications

Last November, I had noted that the extreme backwardation, or declining forward curve, of natural gas futures suggested that the S&P Chemicals Index should start to outperform the American Stock Exchange Natural Gas Index. Gas prices peaked within a month, and despite a worsening manufacturing economy, the chemical stocks, largely DuPont DD and Dow Chemical DOW, have outperformed the natural gas stocks since then.

Relative Performance Comparing the S&P Chemical Index to the Amex Natural Gas Index

Source: Bloomberg

The switch of the natural gas curve from backwardation to contango suggests we do the opposite trade from the one suggested last year. While a rise in natural gas prices is less than certain, the high hedge costs for natural gas and the obvious lack of hedging seen in the summer months indicate the surprises will be on the upside. The uninsured risk-seeker gets hosed in this world. This will hurt consumers relative to producers, so we should be buying the beaten-up stocks of the Amex Natural Gas index and walk away from chemicals and utilities.

Is this kicking them when they're down? Maybe, but the trade is at your risk. Would they do it to you?