Crude/Nat Gas Spread: Catching The Falling Knife

Spreading the Energies

Some of my favorite spreads are in the energy sector.  In particular, I love to trade the crack spreads.  But there’s also another lesser-known energy spread in my bag of tricks: crude oil against natural gas.

A few years ago, the correlation between crude and nat gas broke down.  It lasted for a few years and was not resolved until 2014.  This made for some tough sledding for anyone trying to trade the two markets against each other.  But since the correlation has been back to normal over the last three years, the odds of successfully trading the spread have gone up.  To that end, it looks like a buying opportunity is shaping up right now.

Making Plans for Labor Day?!

Two days ago marked the first day of spring.  Ironically, the trade opportunity that popped up on my radar screen yesterday is for the Labor Day (September) contracts.  I guess that’s why these are called futures contracts, right?

A crude oil futures contract controls 1,000 barrels of crude and a natural gas futures contract controls 10,000 MMBtu (million British thermal units) of nat gas.  To simplify the spread, I plot the difference between the actual values of the contracts.

Over the last couple of years, one September crude oil contract has been worth anywhere from 40% more to a little more than double the value of one September natural gas contract.  Therefore, the blog has been plotting the spread between one crude oil contract and the sum of the value of two natural gas contracts.

Price Parameters

Yesterday the September crude oil/natural gas (x2) spread closed at -$15,930 (premium nat gas).  This was the lowest price it has been in fourteen months.

Notice that this was only the fourth time in the last year that the spread has closed at -$15,500 or lower.  The lowest closing price was the January 20, 2016 low of -$16,170 and the longest that it ever closed at -$15,500 or lower was two consecutive days.

September crude oil natural gas (x2) spread daily

September crude oil natural gas (x2) spread daily

Actually, I fudged on that count just slightly.  The August 2, 2016 close was -$15,430.  That’s only $70 away from the -$15,500 threshold, which is close enough in horseshoes and hand grenades.  So we’ll say it’s close enough for spread trading, too.

Each of the dips to -$15,500 or lower was followed by rebounds that took the September crude oil/natural gas (x2) spread north of -$6,000.  Now interestingly enough, each close above -$6,000 was also a short-lived excursion as well.  Once the spread achieved this level, it soon rolled over and plunged again.  It’s been a perfect trading range for nearly a year and a half.

In light of this, it looks like the trade opportunity here is to buy the spread now and look for a rally above -$6,000 before taking profits.  Also, an ‘add-on’ position could be purchased once the rebound starts.  So that’s exactly how the IMC blog is gonna play it.

Ratio Confirmation

The ratio between the values of a September crude oil contract and a September natural gas contract confirm what we’re seeing in the spread.  The ratio closed at 1.51:1 yesterday.  The last three times it closed at 1.52:1 or lower, a major recovery soon followed.

The biggest challenge for the ratio’s recovery happened in January 2016.  The ratio closed at 1.52:1 on January 12th and didn’t fully recover above this level until two weeks later.  During this time, the contract low of 1.4:1 was established on January 20th.

September crude oil natural gas ratio daily

September crude oil natural gas ratio daily

In the grand scheme of things, though, this extended stay at 1.52:1 or lower was not all that dramatic because the spread only stayed at -$15,500 or lower for two days.  This is why using both the spread and the ratio together is a good idea.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by buying one September 1,000 barrel crude oil contract and simultaneously selling two September 10,000 MMBtu (million British thermal units) natural gas contracts at -$15,500 (premium nat gas) or better.  Initially, the spread will be liquidated on a three-day close below -$16,500.

Trade Strategy for ‘Add-On’ Position:

For tracking purposes, the blog will make a hypothetical trade by buying one September 1,000 barrel crude oil contract and simultaneously selling two September 10,000 MMBtu (million British thermal units) natural gas contracts on a close at -$13,000 (premium nat gas) or higher.  Initially, this ‘add-on’ spread will be liquidated on a two-day close below -$15,500.

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Crude/Nat Gas Spread: Book the Rest of the Profits

End of the Road

The IMC blog entered a long position in the December crude oil/natural gas (x2) spread at -$20,000 (premium nat gas) on August 5th.  The December crude oil contract expires today, so we’re just going to book the profits, sit on the sidelines, and enjoy our Thanksgiving turkey.

december-crude-oil-natural-gas-x2-spread-daily

December Crude Oil Natural Gas (x2) spread daily

However, being on the sidelines does not mean that we are not monitoring the crude oil/natural gas (x2) spread.  We are now focusing our attention on the June 2017 contracts.  That spread is currently priced around -$10,650.  A return to the double bottom between the January and August lows of -$15,960 and -$15,820 would have us watching for a setup to get back in on the long side.  Until then, enjoy your Thanksgiving holiday!

Trade Strategy:

On the long December crude oil/natural gas (x2) spreads entered at -$20,000, take profits here at -$11,600 or better to liquidate the trade with a profit of +$8,400.

Crude/Nat Gas Spread: Take Some Money Off the Table

Best of Both Worlds

The IMC blog entered a long position in the December crude oil/natural gas (x2) spread at -$20,000 (premium nat gas) on August 5th, purchased a second spread at -$15,310 on August 11th, and purchased a third position was entered at -$13,690 on August 15th.

The spread recently soared to the highest level since May, but it is now turning over.  Is this just a temporary pullback after the explosive rally?  Or is it over?

december-crude-oil-natural-gas-x2-spread-daily

December Crude Oil Natural Gas (x2) spread daily

The more important question is do we cash out or hang on?!

The nice thing about having multiple positions is that we can take partial profits.  It’s not a binary “in-or-out” decision.  It really is the best of both worlds.  So that’s what we’re gonna do here.

Trade Strategy:

On the long December crude oil/natural gas (x2) spreads entered at -$15,310 and -$13,690, take profits at -$12,000 or better.

 

Crude Oil/Nat Gas Spread: We Bought ‘Em Near the Bottom

A Wicked Reversal

At the beginning of the month, the IMC blog took a hit on a position on the long side of the December crude oil/natural gas (x2) spread when it smashed prior price support to smithereens.  However, the fact that the spread looked overdone and the fact that the December crude/nat gas ratio appeared to be establishing a double bottom lured us back in.

Not only did we go back in, but we went in aggressively.  The trade strategy was to get back into a long position with an initial exit signal if the ratio broke the double bottom.  Then we’d add more once the spread close back above the “ice level” of -$17k.  Finally, a third purchase would be made if the December crude oil/natural gas (x2) spread could clear the July high and close above -$14k.

This took place over the last week and a half.

December Crude Oil Natural Gas (x2) spread daily

December Crude Oil Natural Gas (x2) spread daily

The blog entered a long position in the December crude oil/natural gas (x2) spread at -$20,000 (premium nat gas) on August 5th, the blog purchased a second spread at -$15,310 on August 11th, and a third position was entered at -$13,690 on August 15th.

We are now loaded up.  Initially, we are looking for the spread to reach a resistance zone between the March 7th high of -$6,840 and the May 18th high of -$5,730.  Once the spread gets into this area, we will monitor the price behavior closely to determine our next course of action.

If the December crude oil/natural gas (x2) spread starts to flounder in the resistance zone, we may take partial or all profits on the trade.

If strength persists, however, we may just sit back and let it ride.  It is possible that the spread could be on its way up to challenge the 2015 high of -$1,540.

Crude Oil/Nat Gas Spread: Aggressive Recovery Strategy

This Energy Spread Tanked

The blog entered a long position in the December crude oil/natural gas (x2) spread at -$17,000 (premium nat gas) on July 22nd and exited at -$22,410 (premium nat gas) on August 3rd after spending  five consecutive days below -$20k.

Broken Spread Pattern

We initially bought the spread because it has exhibited a pattern of making sizable recoveries after closes below -$17k.  This pattern may now be broken since the spread has been below -$17k for two consecutive weeks.

Now that the -$17k level has been broken, it turns into an overhead resistance level.  A great analogy that Peter Brandt uses is that of being out on a frozen lake.  When you are on the lake, the ice acts as support.  But if you fall through, the ice is suddenly a resistance barrier that you must get back above.

December Crude Oil Natural Gas (x2) spread daily

December Crude Oil Natural Gas (x2) spread daily

In the event that the December crude oil/natural gas (x2) spread can climb out of the water and get back above the “ice” at –$17k, it might make sense to get long again.  In addition, a close back above –$17k could indicate that the breakdown was a trap.

The Ratio

Now here’s a twist: While the spread broke down, the ratio may be establishing a double bottom.  This means that the fat lady hasn’t sung yet.

December Crude Oil Natural Gas ratio daily

December Crude Oil Natural Gas ratio daily

The December crude/nat gas ratio closed at a contract low of 12.95:1 on January 20th and rallied to nearly 18:1 by mid-May.  It closed at 13.1:1 on August 2nd and is starting to bounce again.  This has the potential to be a double bottom right around the Lucky Thirteen mark.

Power Play

Here’s an aggressive way to play the current setup.

First, go long in the spread right here and risk a break below the double bottom on the ratio chart.

Second, add another spread on a close back above the “ice level” at -$17k.  This would also place the December crude oil/natural gas (x2) spread closes above the declining 30-day Moving Average for the first time since early June.

Third, add a third position once the December crude oil/natural gas (x2) spread closes above –$14k.  At that point, the spread would be above last month’s high and the first two purchases would have nice open profits.

Trade Strategy:

Place a hypothetical order to buy one December 1,000 barrel crude oil contract and simultaneously sell two December 10,000 MMBtu (million British thermal units) natural gas contracts at -$20,000 (premium nat gas) or better.  Exit if the December crude/nat gas ratio makes a two-day close below 12.5:1.

  First ‘Add-On’ Trade Strategy:

Place a hypothetical ‘add-on’ order to buy one December 1,000 barrel crude oil contract and simultaneously sell two December 10,000 MMBtu (million British thermal units) natural gas contracts on a close above -$17,000 (premium nat gas).  Initially, this ‘add-on’ spread will be liquidated on a two-day close below -$20,000.

 Second ‘Add-On’ Trade Strategy:

Place a hypothetical ‘add-on’ order to buy one December 1,000 barrel crude oil contract and simultaneously sell two December 10,000 MMBtu (million British thermal units) natural gas contracts on a close above -$14,000 (premium nat gas).  Initially, this ‘add-on’ spread will be liquidated on a two-day close below -$17,000.

Crude Oil/Nat Gas Spread: In the Trade…Now Let’s Add!

Picking a Bottom…Or Catching a Falling Knife

Today the blog entered a long position in the December crude oil/natural gas (x2) spread at -$17,000 (premium nat gas).  We’ll exit on a five-day close below -$20,000.

Usually, we don’t like to buy a spread when it’s plummeting.  The reason we took the chance on this one, however, is because it seems to find a bid down at these levels.  The spread finished at -$17,690 today.  As we noted before, the December crude oil/natural gas (x2) spread just hasn’t been able to stay below -$17k for more than a day or two over the last couple of years.  It’s been like trying to hold a helium balloon underwater.  So if you want to try picking bottoms, this is certainly the place to do it.

Pressing Our Luck

We also mentioned in the previous post that the last three drops below -$17k were followed by rebounds of nearly $16,000, approximately $13,500, and $13,300 over the following months.  So we’re looking for a sizable bounce to start soon.  Therefore, we would like to quickly add to the position if the spread does start to recover.

So far this month, the small bounces in the December crude oil/natural gas (x2) spread have ended either side of -$14,500.  Prior drops below -$14k have only lasted four weeks at the most.  Anybody who bought the spread at -$14k or lower and held on never had to wait for more than a month before the position was profitable.

December Crude Oil Natural Gas (x2) spread daily

December Crude Oil Natural Gas (x2) spread daily

Since the spread has already been below -$14k for just over three weeks, we can use a close back above this level as a signal that the bottom is in.  Furthermore, a close above -$14k would mean that the position we entered at -$17k is already showing an open profit.  This would allow us the cushion we need to add to the trade.

‘Add-On’ Trade Strategy:

For tracking purposes, the blog will make a hypothetical ‘add-on’ 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 on a close above -$14,000 (premium nat gas).  Initially, this ‘add-on’ spread will be liquidated on a two-day close below -$17,000.

Crude Oil/Nat Gas Spread: Good Place to Buy

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.

Crude Oil Natural Gas overlay weekly

Crude Oil Natural Gas overlay weekly

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.

December Crude Oil Natural Gas (x2) spread daily

December Crude Oil Natural Gas (x2) spread daily

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.

Trade Strategy:

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.