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Sell the Rally in Natural Gas

The recent bout of record breaking low temperatures has led to an obvious increase in the demand for natural gas and pushed delivery prices up to $4.40 per million metric British thermal units (mmbtu). These are the highest prices we’ve seen since the heat wave and drought from the summer of 2011. In fact, the Energy Information Administration reported the largest natural gas draw for the week of December 13th since they began tracking it in 1994. Furthermore, many analysts expect to break this record yet again with this week’s report. However, in spite of the recent strength in the market, I believe that there are several structural reasons why this rally won’t last and that the pricing of forward natural gas will head lower from here.

Continue reading Sell the Rally in Natural Gas

Natural Gas Finding Support

Natural gas prices have fallen by 25% since its April high, which in and of itself is not a big surprise. Natural gas is notoriously volatile to the point that the market doubling or, halving in price is a common occurrence nearly every calendar year. What interests us is that the current low happens to come near the typical late August seasonal low and also coincides with solid technical support as well as significant buying by commercial traders. Let’s see if we can build a case for a natural gas bottom that may hold through the seasonal low run through the typical end of October seasonal peak.

Three dollars per million metric British thermal units has generally acted as good support going all the way back to the 2008 highs above $20. Rallies meanwhile seem to be stalling around $4.50. Due to the large size of the natural gas futures contract this represents a swing of $15,000 per contract from the $3 support area to the $4.50 resistance area. Therefore, if we can carve out a chunk of the next move while limiting the risk, the reward should take care of itself. The recent action is becoming indicative of a reversal since August 8th when the market made a new low at $3.129, below last July’s low and quickly rebounded to generate the first upside reversal bar we’ve seen since last September.

The fact that the natural gas market appears to be running out of new sellers as we near $3 doesn’t come as a surprise. Using the Commitment of Traders Report (COT) to measure historical trading activity can be a bit misleading, however since there have never been more participants in the futures markets than there are now. The COT report is very useful in determining the mix of market participants, though. Commercial traders in natural gas have been building a substantial long position as the market has declined and their position is now near record levels. Furthermore, short commercial traders (natural gas producers) have trimmed their negative outlook on the market and their corresponding positions by 18% in just the last week.

Seasonally, the natural gas market has a primary peak from mid-May through mid-June. The market then tends to sell off through the end of August before making a secondary peak towards the end of October. The secondary peak is usually fueled by the need to generate electricity to run the air conditioners due to late summer heat, which we’ve had very little of this year. In fact, according to the American Gas Association we’re nearly 12.5% below our average number of “cooling degree days” through August 10th. In spite of the favorable climate the Energy Information Agency shows that natural gas in storage has not grown by the expected amount with reserves running roughly .5% above last year’s level.

The trade that is setting up has very little to do with the long-term price of natural gas which should continue to decline over time. However, the combination of technical action combined with the commercial trader positions coinciding with a seasonal low definitely puts us on the lookout for some type of reversal into higher prices as we head into the fall. Considering the natural gas futures have fallen by 13% since July 18th, we think that a move back towards $3.7 per million cubic feet is totally reasonable. Measuring this against current risk levels we think that it should be quite possible to find a trade risking less than $2,000 per contract and expect a reward of at least $3,500 while holding the position for a few weeks, at most.

Planning Ahead Trading Futures

They say that the most important read for a comedian is timing. The comedy in trading is that the market typically delivers its own punch line at the expense of the trader’s timing. Twenty years of trading has proven one thing right over and over again; traders aren’t meant to get it right. The markets constantly change and a pattern that has been developing for months may be no good on the day the trader pulls the trigger. When the trader is right, they’re lucky to price either the entry or the exit well. Typically, there’s meat left on both sides of that bone. Therefore, the psychological positive reinforcement must come from the bottom line, rather than the lines on the charts. With this in mind, let’s look at some trading opportunities on the horizon and how to prepare for them.

Starting with a seasonal top, unleaded gas should be rapidly approaching its seasonal high. The build in prices tends to peak just past Memorial Day. Whether this is a gasoline producer conspiracy or, purely supply and demand, there’s no argument about when it hurts the most. The unleaded gasoline market has put in a very tradeable top in eight out of the last 10 years during the Memorial Day – June 15 window of opportunity.

Moving to agricultural commodities takes us to the typical weather patterns and their effects on crops. It’s important to understand that the historical seasonal patterns are based on the most probable outcome of a full data set. Therefore, extreme weather events like drought and flood will only register as one year’s data. Thus the historic spikes we’ve seen don’t have nearly the impact when compared to 10 or 20 year’s worth of data. This is why sample size is so important when providing the general guidelines for what’s expected to happen.

Once we get past Memorial Day, we’ll begin looking for a bottom in the live cattle market before June 10th. Fundamentally, the cattle market should be well supported. There simply aren’t many cattle out there. The breeding herd has been on a gradual decline for years. This year is no exception with the 2013 herd coming at the lowest level in 61 years. The tiny herd size provides the market with two different ways to rally. First of all, if corn prices remain low, we’ll see cattle affordably held back for breeding. Secondly, if corn prices rise, we’ll see the herd size continue to dwindle. Either scenario takes steaks off the summer grill.

Fortunately, you’ll be able to finance that new grill using the falling interest rates that typically begin between Memorial Day and the third week of June. Even though some of the newer interest rate contracts may not have the history of cattle, corn or, gold at least interest rate futures all tend to trend in the same direction. The typical pattern is for interest rates peak in the early summer and decline through the rest of the year and into lay-away season.

The final classic summer seasonal trade is to sell soybeans once the planting fears have begun to pass. The soybean market always has support through the planting season. In fact it’s not uncommon for soybean futures to set their high price for the year in May or June. Once the crop is safely in the ground, the market breathes a collective sigh of relief. Given normal growing conditions, the decline in prices really picks up after pollination in July.

The summer markets appear to have gotten off to predictable starts. I think the one, notable exception is the strength in the stock market, which we believe has about run its course. In fact the Russell 2000 – S&P 500 spread trade we mentioned last week appears to have finally turned in our expected direction. The most important concept in these trades is being aware of the seasonal tendencies of different markets as they approach. Mark them down on your calendar. It will take half an hour to do the entire year’s worth for the markets you actually trade. This way you’ll always know if you’re near a market’s inflection point and in trading, predicting inflection points is how we measure our timing.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Bad Year to be Responsibly Average

The Dow Jones has recovered all of its losses since the financial crisis and made a new all time high this week. Unfortunately, most of you reading this will have benefitted very little from its dramatic comeback. However, there are a very few who have benefitted greatly. Professor G. William Domhoff of the University of California demonstrated that the richest 10% own 98.5% of all financial securities. Furthermore the wealth gap between the top 20% and the rest of the population has never been larger. Finally, the growth in income disparity has accelerated under President Obama.

Matt Stoller, of the Roosevelt Institute analyzed IRS data to determine who captured the lion’s share of real average income growth between 1993 and 2010 and found that under President Bush, the top one percent captured 65% of the real average income growth while under President Obama, the top 1% has captured 93% of the real average income growth. The point here is not to choose political sides; after all, income was most evenly distributed under President Clinton. The point is that regardless of what side the politicians are on or whom they pretend to be looking out for, their number one concern is lining the pockets of those that paid for their election. Left or right is irrelevant.

The political system repays two types of voters. It enacts legislation at the highest levels to foster growth in the pharmaceutical, military, raw material and financial industries, thus repaying their campaign contributors. Secondly, the popular vote is increasingly purchased through extended government subsidies on everything from an extension of unemployment benefits and disability claims to housing subsidies and mortgage forgiveness. Every additional dollar doled out through legislation or direct voucher subsidy is a dollar paid to ensure the perpetuation of a system that is withdrawing cash from the middle of our economy and redistributing it between the massive and growing welfare class and the elitist top 10%.

This not intended to slam the unemployed. Frankly, the numbers reported for unemployment like the current measure of 7.9% is woefully under reported when compared to what real unemployment feels like. The Bureau of Labor Statistics reports that there are 8 million people who are unsatisfied workers. These are people who can’t find enough work. They also report that there are another 10 million workers who have given up looking for work. When these 18 million dissatisfied and exasperated workers are added back into the working population a truer picture of unemployment approaches 14.5%. Finally, these numbers don’t reflect another 5 million people who gave up looking for work and are now drawing social security disability.

While many of us haven’t participated in the stock market rally I think one place we’ve shared the climb is at the gas pump. The price of gas has risen steadily over the last month and the Energy Information Administration says that 2012 was nearly the most expensive year on record for American drivers, second only to 2008. They said gas prices accounted for 5.8% of a $50,000 median income. This year’s price increases could push this to nearly 18% of median income and drag another $400 out of the middle’s pockets.

High gas prices stink but at least they’re not the triple economic threat of the Affordable Health Care Act, which will reduce total hiring and hours worked as employers attempt to remain below the hourly and total employment thresholds. The Affordable Health Care Act will also shift more of the deductible payment to the worker as employers seek higher deductible plans to manage the expense of administrating the plan. The Kaiser Family Foundation says this will cost employees about $3,000 in 2013 in added premiums and higher deductibles.

Gas, groceries and health care are issues we all face but the percentage of our budget we use to pay these declines as income grows. A family of four that spends $800 per month on groceries with a $50,000 annual income isn’t going to spend $8,000 a month on groceries if they make $500,000 per year. Therefore the top earners are affected very little by the rising costs of living. Meanwhile, the social safety net continues to pick up a larger portion of the population as job growth and income stagnates at the bottom threshold.

This is the pattern that we face as a country. Bureaucrats acting in their own self-interest with horizons just past the next election are too short sighted to enact long-term legislation. This is how sequestration came into being, as leverage to force Congress into action yet, in spite of their OWN poison pill, the deficit continues to grow unchecked, the voters continue to cast their ballots and the top 10% continue to cover each others’ backs.

Energy Fork in the Road

One economic topic that isn’t getting the attention it deserves is the energy policy. The drought of 2012 along with the expiration of subsidies paid to ethanol blenders will make it nearly impossible to reach the Renewable Fuels Standards (RFS) as early as next year. The standards that were put in place to increase this country’s energy independence were based on protectionist interests and were only viable as long as ethanol produced by the U.S. was subsidized while Brazilian ethanol was simultaneously taxed.

The difference between U.S. ethanol and Brazilian ethanol is the source of their primary inputs. We use corn, which is slower to grow, harder to use and more expensive than the cane sugar Brazil uses as the feedstock for their ethanol production. It will be very interesting to hear how the Presidential candidates debate their renewable energy policies, especially as 40% of our primary crop is diverted from food to energy production. This year’s drought has created a political collision course between food costs and the Renewable Fuels Mandate as well as the Energy Independence and Security Act.

The corn market is about as American as you can get. The U.S. produces as much corn as the next two largest producers, China and Brazil, combined. Unfortunately, production will fall nearly 15% short of 2011’s 314 million tons. The current Renewable Fuels Mandate allotted 40% of last year’s corn to produce 13.95 billion gallons of renewable fuel and 2012 will require an additional 8% increase over 2011. This brings total renewable fuel sources to 15.2 billion gallons on total consumption of 134 billion gallons in 2012.

The drought has pushed corn prices to an all time high of $8.43 per bushel. While the market is now 14% lower at  $7.25, the rally has been more than enough to shatter the profit margins of ethanol blenders. The combination of expiring refining subsidies along with higher input costs is leading to the shut down of major ethanol blenders. This raises the capital market question of who’s going to be responsible for meeting the aforementioned production targets? Ethanol distillers are losing more than $.40 per gallon at the current prices.

The idea of diverting 4.7 billion bushels of an estimated 11 billion bushels in total U.S. production towards an inferior yet, more expensive product seems silly in the face of rising global food prices. This is exactly what would be required to happen to meet next year’s Mandate. Furthermore, reaching next year’s goals using the current 10% ethanol blend is nearly impossible given the current mix of gasoline and diesel motors. Diesel biofuels and biodiesels are given a 50% bonus in RFS for their lower greenhouse gas emissions as measured by the EPA. The friction this creates in meeting the Renewable Fuels Mandate is called the, “blend wall.” The blend wall is the physical limitation of production and blending facilities based on the most common 10% ethanol blend. The mandate calls for 13.8 billion gallons, 10% of expected 2013 US consumption. However, current facilities, assuming they were all open and operating at full capacity, can only produce 13.3 billion gallons of ethanol.

The candidates will have to address the subsidies that farmers and blenders are paid as well as their plan on handling imports. These are most likely, the easy issues to address. Developing a complete energy plan will also include a discussion on the much more economically friendly topic of our vast natural gas reserves which have the capacity to place us on a much more sustainable path.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Global Glut Going Nowhere

The drop in gas prices over the last month has been a relief to us all. The economic sanctions placed by the European Union, Canada and the U.S. on Iran has simply shifted the flow of Iranian crude oil from west to east. The net result has been more oil on the global market with China, India and Russia picking up cheaper oil from Iran due to the lack of competition from western buyers. One would think that cheaper oil to the BRIC countries would be just the catalyst needed to help them develop their own internal demand for goods and services through the creation and evolution of their own middle class. Unfortunately, we are in an economic phase of global deleveraging and even the stimulus of low fuel prices will not keep their engines turning fast enough to save us from a second half slowdown here in the U.S.

The thesis of those who run our economy has been: If we can just provide enough economic grease to keep our own wheels turning the development of BRIC economies will, eventually, create demand for our goods and services. This is still probably true in the long run and the forward demand projection can be used to our advantage through tracking commercial trader purchases via the commitment of traders report. What a different world it has become when our economic horse has become hitched to someone else’s wagon.

China has been trying to engineer a soft landing for their economy through government expenditures on infrastructure and the attraction of foreign direct investment. The struggle can be seen in their manufacturing output, which has declined for seven straight months. They’ve also lowered their lending reserve requirement to stimulate financing which has dropped by 19% year over year and is at its slowest pace since Q1 of 2007. This may simply add further capacity to an already slack market in the wake of China’s 15-year building boom. This is also a futile attempt to increase home ownership, as home ownership is one of the few ways Chinese people have been allowed to invest their newfound prosperity and therefore, already represents an outsized portion of their personal portfolios. The Chinese result will sacrifice its citizens as the high water mark buyers and lead to further class separation between the builders who profited and the people who got stuck with the bill. This will leave them with little disposable income to buy our Apple computers and Fords.

The Chinese situation looks hopeful compared to India. The trouble in India is as much political as it is structural. Indian politics are confusing even to the Indian newspapers. It’s easy to go from the Times of India to India Press or any one of their nearly 2,000 daily publications and find contradictory information. Foreign businesses find it nearly impossible to find the right agencies for the right permits. Even if one does, it is quite possible that the rules will not only change but, be made retroactive thus, invalidating the entire business plan of the entity that just put the whole package together. This is exactly what happened to Wal-Mart between December of 2011 and February of this year. Permits were voided and taxes created by the new policy were made retroactive. Foreign direct investment is drying up rather than fighting its way through the bureaucratic red tape.

This still leaves Brazil and Russia to save us. Brazil just passed England to become the sixth largest global economy. However, Brazil’s balance of trade slipped into negative territory early this year for the first time since the economic crisis and once again ten years prior to that. Furthermore, their latest GDP readings were just positive enough, 0.34% to escape the technicality of recession. They are battling the decline by cutting interest rates for the seventh time in a row. This easing cycle has seen their rates decline by more than 400 basis points, including May’s cut.

Finally, Russia’s economy is shepherded by the fluctuations of natural resource prices on one hand and Vladimir Putin’s political inclinations on the other. The Russian shadow economy remains one of the largest physical cash exchanges in the world. The government recently limited official cash transactions to approximately $20,000 U.S.  Dollars. The political confusion has led to a flight of foreign capital out of the country. Putin’s sincerest desire seems to be the development of a quasi socialist Russia in which the natural resources are shipped abroad by governmentally monitored, semi state controlled companies. Putin then wants access to these revenues to fund his own programs and basically, become the Arab peninsula of natural resources while triangulating politically with Iran and China.

It doesn’t matter whose horse we hitch our wagons to if we’re all headed down the same path. The global balance sheet expansion experiment that hasn’t worked worth a darn in Japan is now being replicated in Europe just as it has been put to work here in the U.S. The world will pull through it and those countries that have been willing to make the tough choices, either through an enlightened electorate body or, the tight fisted hand of an autocratic leader will be the first ones to rebound. Our future, I’m afraid, looks more like the path of Japan’s lost generation than ever.

Food or, Fuel?

Corn is facing unprecedented demand on all fronts. The USDA
reported that prospective corn planting for 2011 is expected to be 5% higher
than last year. That would make this the second largest crop planted since
1944. The 92.5 million acres is second only to 2007’s record of 93.5 million
acres. In spite of the growing acreage in corn and higher yields driven by
greater technology, corn stocks are still down 10% from this time last year. In
fact, the corn on hand versus this year’s expected demand, (stocks to usage
ratio), stands at 5%. This is the lowest number since 1937. There are currently
6.5 billion bushels of corn in storage versus global demand of 123.5 billion
bushels.

The government’s push towards ethanol was actually initiated
by Carter during the oil crisis of the 70’s. It was left dormant until the post
9/11 energy independence push. Corn was trading at $2.25 per bushel in 2001.
Cheap, clean burning corn made it a political win/win for energy independence
and the global warming, green energy crowd. This led to government mandates and
subsidies to increase ethanol production every year through 2015. This year, up
to 40% of the corn crop, at a price above $6.50 per bushel, will be allocated
to ethanol production. If we multiply the intended planting acreage times an
average yield of 155 bushels per acre, we can see that the cost of the corn
input of ethanol production will be more than $37 billion dollars.

The U.S. also exports more than 60% of the corn we produce. Our
exports have continued to climb even as the price of corn has nearly doubled in
the last year alone. Meat consumption has just begun to grow in Asian countries
as they’ve begun to prosper and develop their own middle class. This will not
only continue, it will accelerate. Global meat consumption is still only 20% of
the U.S. average. The demand for feed grains continues to outpace production by
1-4% per year. China is determined to have a self -sustaining hog industry by
2013. These factors help explain the continual decline in ending stocks in the
face of growing harvests.

The demands on the corn market from ethanol and food
production leave absolutely no room for weather related issues. This year’s
crop is crucial to restoring our reserves. Based on the current ethanol
policies, it would have to rally another $.50 cents per gallon just to catch up
with the current price of gasoline. Corn would have to reach $8.82 per bushel
for gas and ethanol to reach equilibrium at $3.15 per gallon. Ethanol/ gasoline
blenders also receive a federal credit of $1.30 per bushel. This pushes the break-even
corn price to $10.12 per bushel for ethanol producers.

The price of corn hit an all time high of $7.79 in June of
2008. Remember, this followed the largest crop ever harvested in 2007. We
already know that global gasoline demand will increase, as fuel must be
exported to Japan. We also know that Japan’s imports of all foods will be
higher than ever. China is doing everything they can to put the brakes on their
economy but it won’t derail the growing appetites of their people. Finally, the
continued decline of the U.S. Dollar will serve as double coupon day for global
shoppers as we remain the world’s supermarket.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Crack Spread and High Gas Prices

The price of gasoline is holding above $3.00 per gallon and bouncing its way higher. This is happening even though the price of crude oil remains fairly well capped technically at $90 per barrel in spite of the Egyptian conflict and concern over control of the Suez canal. The price of crude oil is also showing fundamental weakness at these levels. The weekly commitment of traders report shows a record net short position by commercial traders who are expecting the market to decline from these prices. Furthermore, the gap in prices between current crude oil and crude for future delivery continues to widen. This is called, “contango.” The wider the spread becomes, the more economic incentive there is to sit on and store the oil. In the face of bearish fundamentals, why is the price of gasoline so stubbornly high?

I believe that gasoline demand as a finished product will outpace demand for raw crude over the coming months. A barrel of crude oil equals 42 U.S. gallons.  The refined barrel produces 2/3 gasoline and 1/3 heating oil depending on the quality of the crude oil input. The difference in price between the combined value of the heating oil and unleaded gasoline produced versus the crude oil input is called the, “crack spread.”

The first part of the answer to our question lies in the global dynamics of this spread. Refineries are currently making about $17.20 per barrel that they refine. This is significantly higher than the $6.50 or, so they averaged throughout 2010.  This added profit margin should incentivize greater refinery capacity utilization. This is where the first disconnect becomes clear. Refineries in the U.S. are only operating at 85% of capacity. Our main foreign suppliers are operating at lower levels than that. China, however, ran at record levels of refinery operation throughout 2010.

The Chinese position demands recognition. China sold approximately 18 million cars in 2010 while the U.S. sold just over 12 million. More importantly, the China Association of Auto Manufacturers claims that 2010’s sales pushed Chinese vehicle ownership up to about 6% of the total Chinese population. By contrast there are approximately 80 cars for every 100 Americans. China’s crude oil imports for January have increased by 33% over last year’s and their 2011 projection is for 5.27 million barrels per day. The Chinese are building a wealth of strategic reserves. It won’t take long for them to compete head to head on the open market for the 8.9 million barrels per day the United States currently consumes.

The second primary contributor to stubbornly high domestic gas prices is the mandatory edition of ethanol to the fuel we use. The government mandate is to increase the ethanol per gallon of fuel to 11% from 8.5% for 2011. U.S. ethanol production is uncompetitive because it is based on corn. Sugar based ethanol, like Brazil’s is more efficiently produced. The government’s energy plan currently imposes a $.54 per gallon tariff on imports while subsidizing the creation of ethanol plants and the corn that goes into them. Gas prices topped $4 per gallon in 2008 and  corn is 20% higher now than it was at this time in 2008.

Asian refineries continue to soak up the global supply of crude oil while our refineries enjoy the profits of the crack spread foreign demand is generating. We are sitting near the seasonal lows in petroleum products and the corn market has yet to build in weather related planting premium. Our low operating capacity combined with higher ethanol content and the rising price of corn could create quite a domestic price shock.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Oil Addiction

The United States’ energy dependence has followed the same path as a junkie. We have become addicted to cheap oil over the last forty years. In fact, our entire economy was built on cheap oil. Just like any good junky, we weathered the initial supply crisis in the 1970’s and, having seen the error of our ways, vowed to set ourselves straight. Fortunately, it was just a temporary shock and we didn’t really mean it. Besides, remember how bad it was? It was horrible for domestic employment and inflation was everywhere. We were invaded by foreign automobiles. We were forced to listen to crackpot after crackpot on the evening news telling us that we should be using alternative energy sources available right here in the U.S.  Thank goodness that didn’t last.

 

Fast- forward to 1990 and a tiny little country in the Golden Crescent was having its, “freedom” threatened. Amazingly, one little country, smaller than New Jersey and with fewer people than the city of Houston, was able to mobilize the mightiest fighting force in the world. A desperate addict needing a fix will do almost anything to ensure their supply keeps flowing. The subsequent rally in oil prices was hardly noticed due the prosperous economic times of the period. We got to watch the war on TV with Wolf Blitzer calling the commentary from the video feed on the nose of precisely guided weapons. The technology boom got underway, the war was a huge success and we reveled in national pride.

 

Here we are in 2010 and we’ve gotten used to paying a higher premium for petroleum products and we’ve successfully defended our suppliers. My issue is this; the United States must develop a consistent and focused energy plan if we are ever going to become self -sustaining. We have the resources. The U.S. has greater natural gas reserves than the Saudi’s have oil. This past week I’ve read two alarming pieces targeting the future of the United States’ energy consumption. After doing some research on my own, it has become clear that there is a major disconnect between where we are being told we are headed versus where we actually are headed.

 

The government stimulus packages and vehicle emission standards have pushed for electric cars as the primary source of green energy. It’s made for great press as our ailing auto manufacturers have produced catchy, warm and fuzzy commercials and brainwashed the general public into believing we are on the road to self-sufficiency, leading us away from foreign oil dependency and the wars it has brought with it.

 

However, if look behind the Wizard’s curtain, we reveal some startling facts.

The U.S. currently imports 67% of its oil.

The cessation of Gulf oil production will increase this to 75% by 2012. This will put oil at $125 per barrel and gas at $4-$5 by 2012.

Half of our top ten oil importers are countries that are unsafe to visit according to our State Department. Their official language reads, “Travel Warnings are issued when long-term, protracted conditions that make a country dangerous or unstable lead the State Department to recommend that Americans avoid or consider the risk of travel to that country.” This includes countries like, Iraq, Nigeria, Saudi Arabia, etc.

According to T. Boone Pickens, our current energy policy prices in oil at $300 per barrel by 2020. Oil is currently just over $80 per barrel.

 

I wrote about the spread between natural gas and crude oil a few weeks ago stating that it was near an all time high. The spread between any two markets is based on using a standard measure for both to determine absolute value. Energy markets are measured in British Thermal Units, BTU’s. This defines how much work or, power, is generated by the combustion of a given quantity of substance. The current relationship between crude oil and natural gas is that it takes $14.07 worth of crude oil to do the same work as $3.80 worth of natural gas. This means we pay about 3.7 times as much for crude oil to do the same amount of work as we would for natural gas. The five- year average for this ratio, including today’s inflated price is, 1.7.

 

Natural gas has always sold at a discount to crude oil and until the last 10 years, the relatively low price of crude oil has dictated business as usual. In the wake of 9/11 and the global recession, the government has spent hundreds of billions of dollars aimed at stimulating the economy, nurturing energy independence, cleaning up the environment and improving the infra structure of the country. Unfortunately, the money from that pie, our tax dollars, have been sliced so thinly that the result is virtually, nil. Our dollars’ have been spent on a Jack-of-all trades and master of none. This is most clearly evident in the outside investment and performance of alternative energy source companies specializing in wind, geothermal, solar and fuel cells, which have all lost at least 30% over the last year. Clearly, the investment community has little faith in the current administration’s ability to coordinate a sustainable alternative energy plan.

 

Finally, the push towards electric automobiles is simply a public relations gimmick. According to the U.S. Energy Information Administration, highway diesel usage trumps residential gasoline consumption by more than an 8 to 1 margin. Does it really make sense that the government enacted emission restrictions on passenger vehicles prior to commercial vehicles? Electric, residential automobiles with two seats and a 100 mile range are not going to effectively address the problem of energy independence.

 

The primary focus of our energy policy should be natural gas. It burns 30% cleaner than crude oil and nearly twice as clean as coal, which it’s also currently cheaper than. Finally, in energy equivalents, apples to apples, we have three times more energy reserves than Saudi Arabia. We should regain our dignity by developing the infrastructure, creating fueling stations and putting our people to work through the use of new technologies with an extended shelf life. This is a fundamentally sound path towards a cleaner, more productive and independent country.

 

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Crude Oil vs. Natural Gas Ratio Spread

This week’s trade has been all about the spread between natural gas and crude oil. Using inter-market analysis allows us to compare the value of substitute goods. In this case, we can compare the price of crude oil to the price of natural gas to determine what price levels it becomes cost efficient for the markets’ participants to shift their energy needs from crude oil to natural gas and vice versa. The key to this type of analysis is using the proper pricing methodology. The calculation of the crude oil vs. natural gas spread is done using a ratio spread. Dividing the price of natural gas, currently around $4 per million metric BTU’s into the price of a barrel of crude oil at $77 gives us a ratio of 19.25. This ratio peaked at an all time high of 22.7 in April of this year.  A spread ratio closer to 12 would represent an average relationship over the last few years.

 

The trick to trading this ratio is to try and create equal dollar movement in both contracts. We want the trade’s profit or loss to be accurately reflected by the ratio’s movement. If we were to simply do a one to one spread, buying natural gas and selling crude oil, we would end up with an imbalance on the side of the trade that has the largest daily dollar movement.

 

This problem is solved by using the average daily range multiplied by the market’s point value to provide us with the average daily dollar fluctuation of the individual markets. Crude oil’s nine day average range is exactly $2 per barrel. There are two sizes of crude oil contracts, the full size and the half size. The full size is $1 per point, which means an average daily range of $2,000. The half size obviously yields an average daily cash fluctuation of $1,000. The natural gas market has an nine day average range of .1563. This market also has two contract sizes. The full size contract which, has a daily cash fluctuation of $1,563 and a quarter size mini contract which, fluctuates about $390 per day.

 

Now, we have the pieces to construct a trade that is dollar value neutral and will accurately reflect our natural gas to crude oil ratio spread. Ideally, we would sell one full size crude oil contract with a daily fluctuation of $2,000 and buy one full size natural gas contract with a fluctuation of $1,563 plus an additional purchase of one mini natural gas with a daily fluctuation of $390. This gives us an average of $2,000 daily movement in the crude oil and $1,953 daily fluctuation in the natural gas.

More information on crude oil and natural gas can be found at NY Energy Futures.com

 

This type of ratio spread can also be used in grain markets when trying to spread corn or wheat against beans or even the corn to cattle spread. Please call with any questions regarding this trade or, spread trading in general.

 

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.