Natural gas is playing a larger role in the energy industry. Once thought of as a byproduct of oil production, natural gas is now used in a variety of ways, from residential uses to industrial, to electricity generation. Natural gas cars are now a reality, with around 12.7 million natural gas vehicles worldwide as of 2010. It is the cleanest burning fossil fuel and economically friendly, contributing to about 25% of the United States' energy use, so it is no wonder why it is serving as an alternative to other fossil fuels. With this in mind, investors should be armed with the information they need to make the proper investment decisions regarding natural gas investments. Going through who uses natural gas, how it is transported, its storage capabilities, pricing, trading methods and spot and forward markets, investors will have the tools they need to better understand this clean burning commodity.
Nationally, the single largest factor affecting demand for natural gas is temperature. During the winter, natural gas is used for heating while during the summer, it is often used to power air conditioners. The demand and price of natural gas thus fluctuates whether it is summer or winter. During the winter, demand is at its peak and so prices adjust accordingly. (For related reading, see Become An Oil And Gas Futures Detective.)
Users of Natural Gas
The three largest users of natural gas are industrial, domestic and power generation. Of the three, the use of natural gas for power generation has risen the quickest. By getting to know who uses natural gas, investors can better gauge how demand affects pricing.
Industrial users often use natural gas as a source of heat. It ignites quickly and turning off a natural gas furnace doesn't waste any fuel. Stopping the fuel source can easily put out a natural gas furnace. In comparison, a coal furnace will continue to burn until the coal is depleted. This makes it far more expensive if the coal furnace has to be started more than once.
The largest residential use of natural gas is home heating, especially in the winter. About half of the homes in North America use natural gas for heating. Other uses include boilers, furnaces, water heaters and outdoor barbeque grills. It can burn up to 2000°F (1093°C) from a simple stovetop, making it a powerful domestic cooking fuel.
Power plants are the fastest growing users of natural gas, since natural gas powered plants are more environmentally friendly than coal or oil based plants. Some natural gas power plants operate year round, while others are more seasonal.
Natural gas is most commonly transported via pipelines. This is primarily due to natural gas having a relatively low amount of energy per volume and the additional cost that containers would add. To compare, a barrel of oil has the same energy content as about 6,000 cubic feet of natural gas or a 6:1 ratio. An alternative is liquefying natural gas to get more energy content per volume. This is not as cost effective as transporting via pipelines however, as it needs to be cooled to -260°F (-162°C) to be liquefied. As a result, it is primarily used in this form for storage or for natural gas cars. To get an idea of how much power even liquefied natural gas (LNG) contains compared to gasoline, LNG only holds about two-thirds the energy for the same volume.
Depleted Gas Reserves
Economically viable due to being able to be reused, depleted gas reserves are the most common and cheapest form of underground storage. Typically, these storage facilities are operated on an annual cycle, withdrawn during the peak winter months and injected with gas during the off-peak summer months. How close the depleted gas reserve is to the pipeline infrastructure and key gas markets, also plays into how economically viable the storage will be. To maintain the proper amount of pressure in depleted reserves, about 50% of natural gas must be kept as cushion gas.
Underground permeable gas formations, aquifers act naturally as water reservoirs. More costly than depleted gas reserves, the entire infrastructure must be developed from scratch, everything from the installation of wells and pipelines. Because of this, aquifer store requires more natural gas cushion than a depleted gas reserve. About 80% of the total gas volume is cushion gas.
Salt caverns are well suited for natural gas storage. The walls are strong and gas cannot leak. Cushion gas requirements are low, typically around 33% of total gas capacity. However, salt caverns are smaller than depleted gas reserves and even aquifer storage facilities, typically only holding about one-one-hundredth of the amount of storage of a depleted gas reserve. One key advantage, however, is the ability to quickly store and remove natural gas resulting in more withdrawal and injection cycles per year, as compared to the previous two methods.
Natural Gas Hub
A hub is where two or more pipelines connect with each other. The most important hub for natural gas in North America is the Henry Hub, located along the U.S. Gulf Coast. Here, the benchmark for natural gas prices is determined and traded for delivery on the NYMEX natural gas futures contract. It is the average of the natural gas prices traded at this location from 13 interconnected pipelines. (For related reading, see Fueling Futures In The Energy Market.)
Natural gas trading terminology is different than other markets. When quoted by a trader, the price is the difference between the Henry Hub price and that location's price, called the basis price. Basis differentials can be caused by weather, natural gas pipeline capacity, among other factors. However, if you ask a utility operator the price, it would often be the actual price of natural gas. Regardless of the price quoted, the cost is the same to the consumer. Based on this terminology, a trader may make a basis position having exposure to two different locations: the Henry Hub price and that location's price. An actual position, also referred to the all in price, the trader would be exposed to the price of gas at only one location.
There are several methods of trading natural gas. The simplest is taking a directional position, profiting from whether the price goes up or down depending on the position taken. However since natural gas is cyclical, traders tend to speculate on the price taking spread trades. Here are a few:
This is where an investor would buy natural gas when it's priced low and sell it when it is priced high. This is only possible if the trader can store natural gas for a set period of time. Since even on a weekly basis natural gas prices can be volatile, it is possible to buy during a low demand time period and sell when demand picks up, say at the start of the week. (For related reading, see Introduction To Swing Trading.)
This is betting on the price difference between two locations. As the price of natural gas can vary from location to location, there can sometimes be a substantial difference between the two locations. This is not helped by natural gas transportation not being instantaneous and storage can be limited.
These trades are based on the difference between natural gas and electricity pricing. Generally, the two trade together, but since they are determined using different mechanisms the prices can sometimes differ, with traders taking advantage of the volatility.
Also called calendar spreads, these trades are where the trader bets, for example, that the summer will be warmer than usual, boosting natural gas prices, thus buying summer gas and selling winter gas. (For related reading, see Pencil In Profits In Any Market With A Calendar Spread.)
While trading natural gas futures can be an option, other alternatives include investing in fully integrated natural gas companies or getting exposure through natural gas ETFs. It is up to the investor and their situation and sophistication to decide which method to use.
For trading natural gas, the U.S. gas inventories report is often used to gauge current supply and demand from the previous week. This is issued by the Energy Information Administration (EIA) every Thursday afternoon at 3:30 p.m.
Spot and Forward Prices
Spot markets are prices for immediate delivery, whereas future markets are for delivery for some time in the future. These are two very distinct markets that are fundamentally different in the natural gas market.
In the spot market, the prices are the supply at hand and demand at hand; if there is a shortage then prices can act erratically, as it is difficult to move extra supply from storage on such short notice. In comparison, the futures market is less volatile, mostly being determined by macroeconomic variables of seasonal supply and demand expectations.
As a result of this key difference between forward and spot markets, the pricing closer to the delivery becomes less certain. This is because any complications in delivery can have an adverse effect on natural gas prices. However, this volatility in the spot market does not typically affect the forward pricing. Forward pricing tends to follow a regular pattern: high prices during the winter and lower during the summer. (For related reading, see What Is The Difference Between Forward and Futures Contracts?)
The Bottom Line
Investing in commodities such as natural gas can be complicated and hard to understand. Natural gas use is becoming more prevalent and by knowing the fundamentals of natural gas, investors can make better decisions on when to buy or sell.