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September 3, 2009

Natural Gas Spreads

There has been a lot of chatter recently about how cheap natural gas has become, and a lot of people are trying to call a bottom. A popular vehicle for bottom callers is the natural gas ETF, symbol UNG, but these shares are probably the worst way to play natural gas due to the huge premium to NAV they are currently sporting. UNG is also facing regulatory issues and some serious contango.

Personally, I don't care to guess whether natural gas goes up or down. Even if one believed NG were about to rally, what contract month do you buy? Prices are already double only 5 months out. The most prudent way I see to trade natural gas at this juncture is a method that takes advantage of behavior related to the current supply glut. The glut is causing the front month contract price to fall away from the next month (widening contango) as suppliers dump gas on the spot market to get cash.

I decided to repeat a strategy I successfully executed in oil 10 months ago by putting on a calendar spread in NG in an attempt to profit from these widening spreads. I went out 3 months and sold Jan NG versus long Feb NG. The current spread is 5.8c. Assuming a sudden shortage of NG does not appear, one would expect the same behavior to repeat. The current Oct/Nov spread is $1.20. The Nov/Dec spread is 85c. I am looking to hold this play until the 2nd week of Dec... a week or two after the Jan contract becomes front month. I don't know if the spread ultimately will be as dramatic... probably not if NG starts to rally... but the potential reward of 40c to a dollar versus the potential loss of 6c (I get stopped out if the spread goes backward) seems worth while.


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