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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved

Wednesday, September 22, 2021

Winter is Coming - Natural Gas in Limelight

By Century Financial in Investment Insights

Winter is Coming - Natural Gas in Limelight
Winter is Coming - Natural Gas in Limelight

*Trading in financial market carries risk and can result in loss of capital.


The product and investment ideas do not consider the risk profile and financial position of the recipient and may not be suitable for everyone. Trading in financial markets and use of margin involves a significant risk of loss, which can exceed deposits. Please read the complete disclaimer carefully.

Winter Energy Crises

Europe is bracing for a tough winter as an energy crisis that’s been around for years leaves the continent relying on the whimsy of the weather. The environmental policy has also pushed some countries to shut their coal and nuclear fleets, reducing the number of power plants that could serve as back-up in times of shortages. Additionally, China jumped back into the LNG spot market this week, with one of its top importers releasing a large purchase tender for a strip of cargoes through March.

Dependence on US

Energy demand is rising from the U.S. to Europe and Asia as economies recoup from the global pandemic, boosting industrial activity and fueling concerns about inflation. Prices are so high in Europe that two major fertilizer producers announced they were shutting plants or curtailing production in the region. Moreover, as Chinese utilities in Beijing become locked in bidding wars for shipments of the super-chilled fuel, the price to produce electricity and heat homes will surge. The international spike in demand will lead to increased natural gas cargoes from the US, as it is the second-largest natural gas exporter globally.

Why Natural Gas?

Several factors came together to drain natural gas supplies: An extended cold winter in 2020 in both the US and Europe; low gas prices and general economic uncertainty during the pandemic induced many drillers to stop production. Moreover, Hurricane Ida in August temporarily knocked out gas drilling in the Gulf of Mexico; and the below-average electricity generation from hydropower dams in the western US and European wind farms forced grid operators to fill the gap with gas.

The chart below demonstrates the spike in the price of Natural Gas for the past thirty years.

The price of natural gas is currently at $4.866 as of 22nd Sept 2021, the recent crunch in supplies has allowed the prices to climb over resistance levels of $4.627 which has been capping prices since 2010.

In addition to long term spike in demand for natural gas over the winter months, historically, October has proven to be a stellar month for the commodity in terms of seasonality.

The table below depicts seasonality of Natural Gas for the past 20 years.

The commodity has average returns of 8.96% for the span of 20 years and has a hit ratio of 75%. Empirically, max gains have been over 45%, while max losses are floored at 12.5% for the commodity in the month of October. Pent up demand in the winter and bottlenecks on the supply of the commodity is forecasted to further boost the prices of Natural Gas.

How to Play the Natural Gas Shortage?

Strategy 1: Long a Natural Gas Nov 2021 Futures Contract – This will enable to capitalize on the Oct 2021 run of Natural Gas. (Margins have been calculated as per CMC platform)

Nov '21 Futures Contract
1 contract = 10,000 Units
Price per Unit $4.8
Units $10,000
Amount $48,000
Amount $4,800

Strategy 2: Long a Naked Call Option – Another process to enter play the natural gas rally can be through options. Going long on a call option will enable unlimited upside with lower margins but at a premium.

Long Call: Nov '21 Futures
1 contract = 10,000 Units
Strike Price $4.8
Premium Outlay per Unit $0.427
Total Outlay $4,270

Strategy 3: Bull Call Spread – A bull spread strategy using call options will allow for upside will a lower premium outlay.

Bull Call Spread: Nov '21 Futures
1 contract = 10,000 Units
Long Call (At the Money)
Strike $4.8
Premium Outlay per Unit $0.427
Short Call (Out of the Money)
Strike $5.6
Premium Received per Unit $0.174
Net Premium Outlay Per Unit $2,530
Total Outlay $2,530

Although the total outlay for the third strategy is approximately half of the second strategy, the gains are capped at $5.6 (which may act as a resistance for Natural Gas)

The table below provides a comparison of returns for strategy 2 and 3.

Scenarios on 26th Oct 2021: Bull Call Spread Long Call @ $4.8
Price Returns
$4.40 -5.21% -8.75%
$4.60 -5.21% -8.75%
$4.80 -5.21% -8.75%
$5 -1.04% -4.58%
$5.20 3.13% -0.42%
$5.40 7.29% 3.75%
$5.60 11.46% 7.92%
$5.80 11.46% 12.08%
$6 11.46% 16.25%
Payoff for Bull Call Spread

Bull Call Spread Payoff Bull Call Spread Payoff

Risks and Assumptions for Back-tested trading strategies
The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
Unforeseen events can lead to variation in performance from the tested trading strategy.
The tested result has been computed with price feeds available from Bloomberg.
The testing environment has not considered transaction or any other costs.
Trading indicators used for the purpose of testing has been provided by Bloomberg.
The strategy might suffer from data mining fallacy, selection bias and backfill bias.

Data Source: Bloomberg
Data & Prices as of: 22/09/2021

Arun Leslie John
Chief Market Analyst

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