Running On Low Energy
Crude oil and natural gas have a strong correlation. But that’s not always the case. Starting in 2011, the correlation broke down when crude went into a trading range while natural gas endured a bear market decline into the spring of 2012, followed by a bull market into Q1 of 2014.
The two markets got back in sync in early 2014 as they both peaked out and started a bear market that pushed them to multi-year lows by the start of this year. Crude and nat gas have both been on a tear since then as well.
Although crude oil and natural gas are both members of the energy sector, the different dynamics in supply and usage can cause deviations in the correlation. But the fact that they eventually get back in sync makes for potential spread trade opportunities.
Bottom of the Barrel?
Over the last two months, natural gas has outperformed crude oil. This is because of the increased usage for natural gas. It’s used in air-conditioning and another record hot summer here in the US has definitely put a demand on this commodity.
Despite the summer demand, it appears that the December spread between the value of a 1,000 barrel crude oil contract and the sum of the value of two was 10,000 MMBtu (million British thermal units) natural gas contracts has reached a point where it may be a buying opportunity.
The December 2016 crude oil/natural gas (x2) spread bottomed at -$17,540 (premium nat gas) on December 18, 2014. It then rallied nearly $16,000 over the next four months.
The next time the spread went into a downtrend, it bottomed out at -$17,180 (premium nat gas) on August 24, 2015. It then rallied approximately $13,500 in a little over two months.
The next downturn ran the spread to a new contract low of -$19,030 (premium nat gas) on January 20, 2016. The recovery that followed ultimately took it $13,300 higher four months later.
On July 8th the December 2016 crude oil/natural gas (x2) spread closed at -$17,070 (premium nat gas). Given the fact that the spread has not stayed below -$17k for very long over the last couple of years, it seems that the way to bet here is on the long side. So that’s what the blog is going to do.
FYI: We are also monitoring the June 2017 and December 2017 crude oil/natural gas (x2) spreads. If they break down a bit further we may start positioning on the long side of these spreads as well.
For tracking purposes, the blog will make a hypothetical trade by buying one December 1,000 barrel crude oil contract and simultaneously selling two December 10,000 MMBtu (million British thermal units) natural gas contracts at -$17,000 (premium nat gas). Initially, the spread will be liquidated on a five-day close below -$20,000.