There are some prices in the market that have even the casual observer, if not the market veterans, scratching their heads and asking questions. For some, that may mean a rise in the stock market. For others, that may mean depressed natural gas prices. I know last month when I was a guest on the “Options Insider” podcast with Mark Longo, the audience was asking about natural gas prices and whether I thought they had the chance to breakout any time soon. For an economy that has held up better than many expected and a commodity that is levered to the economy, the level of futures was leading to questions. 

This should not be surprising. When I look at the path of futures prices this year relative to the path taken over the last 10 years, I have never seen more consistently lower prices. The light blue line in the graph below is this year. The darker blue line is the average over the last 10 years. Not only has the path of prices been lower than average, but the path has also been below every year of the last 10 years for the entire year. 

We can see this not just in the front month futures but across the entire futures curve. A simple analysis of the nat gas commodity futures curve shows that while we see the typically seasonality throughout the year, the so-called should seasons of March-April and September-October, the entire futures curve is much lower than where it was a year ago. This suggests to me that we are seeing the same cyclicality we might normally expect, but there may be something more secular at work in terms of supply and demand. The cyclicality that is normally due to expected usage surrounding the weather is still quite evident. In fact, the spikes are expected to be slightly larger than historically, perhaps due to the low current prices. Even as we look at futures prices 10 years ahead, they are still much lower than average. 

We see this as well in the long-term technical chart of the generic first contract for nat gas. At $2.75, prices are much closer to the 20-year lows of $1.75 than at the 20-year average of $4.65. That said, a base appears to have been formed around $2 with that level having been tested several times this year and holding. While prices are still below various moving averages and therefore facing some resistance on the upside, there may be a sense that the reward to risk could favor the upside with a base having been built.

One reason we might be seeing a base forming is given some recent headlines that have come out regarding liquified natural gas (LNG) terminal approvals. A quick Google search shows that the expectations for LNG terminal approvals coming into 2023 was quite low. In fact, several articles suggest that no major plants were expected until 2024. LNG is a major potential source of new demand for U.S. natural gas, and with shortages in Europe given the removal of Russian nat gas from many market participants, this driver may shift the demand and supply dynamics going forward. As the Reuters article shows, LNG developers are on track to approval three terminals with volumes of 5.1 bcfd of gas, a record for any year. In addition, the recent debt ceiling deal approved the Mountain Valley pipeline, a project championed by Senator Manchin, that adds even more potential demand for gas, this time coming from West Virginia into the Southeast. Traders may look at these developments and sense the balance of demand and supply is changing.

Any long-term shift in demand for natural gas is a welcome development. Historically, one might suggest there is the possibility for power plants to switch between oil and gas, and this relationship would hold prices in check. The historical expected switching rate is at a ratio of approximately 6 to 1-- given this is the thermal parity also know as the BTU ratio--since a barrel of oil is equivalent to 5.85 MMBtu. For a quick primer or refresh on this, I would recommend the CME Group article, Are Crude Oil & Natural Gas Prices Linked? As we can see, this ratio effectively held through the early 2000s. However, from about 2004 onward, this ratio has not held at all, with consistently more demand for crude oil than nat gas sometimes pushing this ratio well over 50 to 1, in spite of the thermal parity relationship. Currently, this ratio is about 1 standard deviation above this multi-decade mean; however, if we look just since 2005, it is much closer to the mean relationship. What gives?

The potential source of what appears to be a disconnect is due to the global vs. local nature of crude oil vs. nat gas. As we can see from these correlation charts put out by the EIA, crude oil is a global product, easier to chip around the world. As such, the correlation of WTI and Brent is quite high. Nat gas, on the other hand, is much more local. We can see that when we compare U.S. vs. Asian vs. European nat gas, there is historically no correlation. Going back to the crude vs. nat gas spread analysis, this suggests that the global demand for crude vs. the local demand for nat gas means that despite a thermal parity relationship, the different sources of demand suggest this ratio need not hold as all participants cannot access at the same prices. With more LNG terminals being developed, and the potential for more global demand for U.S. nat gas, is it possible that something that looks like the historical relationship could again take hold? This would take several years to happen, given the 3-5 years it takes to build an LNG export terminal; however, traders may begin to anticipate this changing nature of demand and supply and start to trade accordingly.

We may be seeing this change in sentiment in nat gas. Not only has a base been built around $2, but we are seeing the generic front month futures prices break out above the Ichimoku cloud, or the level where most of the volume has transacted over the last several weeks. This suggests the bulls are taking control of this market, and we can also see this in the moving average convergence divergence (MACD) in the middle panel, which has crossed higher and is beginning to trend up. Finally, looking at the relative strength index (RSI) in the bottom panel, we are not at overbought levels yet, suggesting there may be more room to run.

Before I decide how to play this in the options market, my first stop is to look at the implied volatility term structure, to see if the market is favoring some tenors over others. It is very apparent to me that the very front part of the curve is where the action is, with demand for very short-dated options clearly outstripping supply as evidenced by the almost 90 implied volatility vs. a level in the mid-60s further out into the summer. While these implied do drop rather precipitously, there is still a premium in the weekly options in July over the standard contracts further out. This tells me there may be an opportunity to look at calendar spreads, even if they are shorter dated calendar spreads.

The next stop for me is to look at the open interest and get a gauge for where traders have been taking their positions. Looking at this data in a year-to-date basis, we can see that there has generally been a preference for puts over calls beginning at the end of January through early May. Considering the daily technical chart, the preference for puts corresponds with the fall in futures that picked up in January. The balancing back toward calls since May corresponds with the base that may have formed around $2. At a ratio of 1, the options market appears relatively balanced between demand for puts and calls.

This is somewhat corroborated by the Commitment of Traders (CoT) report on nat gas futures. We can see managed money had built up a sizable short coming into the year and this stayed in place through the end of February/early March. That short was covered into April, leading to a stabilization in futures. From April through June, the short was built back up but it is being reduced again, consistent with the timing of the recent move higher. There is a potential for more short reduction by managed money, if these traders feel there may in fact be a breakout occurring.

I do not see any bullishness building up in the skew of the implied volatility. While the put vs. call open interest is more balanced, when I look at the traders’ expected volatility on moves higher vs. lower, I can see there is still more expected nervousness for a move lower than higher, as evidenced by the volatility skew. In fact, call options that are closer to the at-the-money (ATM) are actually trading below the ATM levels. Perhaps I am seeing some profit-taking via call option overwrites to long underlying positions. I certainly don’t see nervousness of a sharp move higher

The volatility surface view in QuikStrike enables a trader to get a very comprehensive view of the relative implied volatilities not only for calls vs. puts of the same expirations but calls vs. puts for each expiration. It is a combination, in a sense, of both the term structure and skew charts. We can see where there may be volatility premia and discounts for various expirations and variations moneyness. This is a very useful chart for helping to determine how one might want to build out a spread trade that takes advantage of a directional view. For instance, one can see the very high levels of ATM volatility at the front part of the curve. One can see that there is a premium for puts over calls, but this may be more pronounced in percentage terms the further out one looks. Given the first two contracts will be at or near expiration by the time you read this, I am going to begin my analysis with the weekly LN1N3 options. There is still premium in the ATM options that trade around a 74 implied vol vs. the 65-66 implied that the curve normalizes at. In addition, I can see that the puts that are 15-20% out of the money (OTM) have a much bigger premium than those that are closer to ATM. Continuing into the LN2 and LN3 contraction, as I can see that on the call side of the ledger, options that are 10-15% OTM trade at roughly the same level as the ATM. This gives me an idea of how I want to set up my spread trade.  

I want to take advantage of this relative pricing by selling short-dated options and buying options that are further out. If I focus specifically on the weekly options, and use the LN1N3 and LN3N3 options, I can gain a premium in implied volatility terms by selling the front and buying the back. Both weekly options settle into the same futures, which is currently around $2.86. As I am bullish due to the potential breakout in futures as well as the potentially improving long term demand for nat gas, I want to have a bullish strategy.  Puts have a premium over calls so my bias is to sell puts and buy calls. Given the highly volatile nature of nat gas, having open-ended downside from selling outright puts is difficult if not impossible for many accounts. Thus, I look to sell a put spread and use that premium to buy outright calls. This gives me limited downside but unlimited potential upside.

I have chosen the LN1N3 2.85-2.65 put spread. You can see that both options have implied vols in the 74-75ish range, so even though I am buying downside puts to limit my risk, since the option I have chosen is closer to ATM the premium is not as high. This spread takes in about 8 ticks and is long 20 deltas while short gamma and vega.

I use this premium to buy LN3N3 call options. I have to go a little further out of the money for these as I buy the 3.20 strike which is a 29 delta. We can see I am paying less than a 68 implied which means the options are still about the same as the ATM. Also, at a 68 vol, it is lower than the puts I am selling so I am getting a premium due to the term structure of volatility. I have to spend a little more than the 8 ticks but all in all, the spread is very close to premium neutral. I am long gamma and vega from these options, so from the beginning the spread is net long gamma and vega–though this is very path dependent–with moves higher getting me longer the Greeks but moves shorter reducing this long gamma profile. This is potentially a risk to manage.

The resulting position has a payout profile that resembles a long futures contract at inception. However, at expiration of the short put spread, it has more distinct risks. We can see that if the futures are 2.85 or higher, the put spread expires worthless and the trader is left with a long outright call, for which they paid very little if any premium. This is the “free options” that you can get from the calendar spreads. It is not free of course, because there are risks. The cost comes from the potential for losses between 2.85 and 2.65 that you can see in the graph above. If the futures are between these levels at the time of the first expiration, the trader will experience a loss on the short put spread. 

I look at these losses as putting premium back onto the call option that right now appears free. The current outright cost of the call is 8.6 ticks, so any loss on the spread less than this, I am still better off than just buying the calls. This would mean to me if the futures are roughly above 2.77, I feel I am better off. The maximum potential loss, however, is the difference in strikes or 20 ticks. I would realize this with futures 2.65 or lower. In my paradigm, this means I would be spending 20 ticks for a call I could have spent 8 for, and I am spending it when futures have already moved against me. This is potentially unappealing for some. However, this is the risk of putting on a spread that has an attractive upside profile. Since I think the futures are breaking out, and there is more potential demand to drive this from a possible reduction in shorts, this is a risk I am willing to take to gain leverage to this directional move. 

We might be at an inflection point in the nat gas futures market. This market has been the source of some consternation by traders this year, but perhaps that is being resolved. We have some potential fundamental catalysts and a likely technical catalyst. By looking at how the market is pricing the possibility of various moves, and the timing of those moves, a trader can potentially create a spread that provides attractive reward to risk and attractive leverage to a directional move. Nothing is without risk, but if the trader knows the risks ahead of time, problems and losses can be anticipated and these risks can be managed. 

Good luck trading!

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