Many natural-gas traders, including operators of storage facilities, depend on seasonal price spreads to earn reliable returns. Traditionally, they buy natural gas in the summer, when prices fall, and then sell during the winter, when prices go up.
That strategy has been tested recently, however, as an oversupply of shale gas has narrowed seasonal spreads. In this environment, how can traders extract value beyond the summer-winter pricing? History suggests two approaches that exploit daily price moves.
As the chart below illustrates, the seasonal spread narrowed to $0.25 per 1 million British Thermal Units (MMBtu) as of Dec. 31, among the smallest in the past eight years. The tightening has sparked renewed interest in dynamic storage strategies that exploit seasonal price fluctuations and short-term volatilities.
Summer-winter spreads have tightened amid an abundance of shale gas
Source: NYMEX Natural Gas Futures
Traders tend to use one of two strategies to monetize their stored natural gas. The first, a “cash-only” strategy, is based on the price volatility of the day-ahead market. Instead of hedging price spreads outright, a trader using this approach takes an unhedged position in the cash market while attempting to buy low and sell high. This allows a trader to exploit the usually predictable decay of the cash price, but leaves the stored natural gas unhedged, creating significant downside risk in the event of price volatility.
The second approach, a “rolling intrinsic” strategy, is more conservative and a bit more complex. On each day of the storage operation, a trader calculates a new storage value and its associated hedge in the futures market. If the daily price changes so that a better futures contract can be placed, then the trader will roll into the new hedge position (assuming liquidation costs are reasonable). In short, this allows the trader to gain a rolling profit, while maintaining a hedge against volatility.
In a backtest using the MSCI FEA® @ENERGY/Storage model, both storage strategies improved returns compared with the traditional summer-winter spread alone during the eight years that ended Dec. 31 (see chart).
Dynamic storage strategies outperformed summer-winter spread
Source: Backtest via MSCI FEA® @ENERGY/Storage using NYMEX Natural Gas data
While a cash-only strategy appeared riskier, the rolling intrinsic strategy offered a more conservative approach by providing a completely hedged position. Note that the model helped evaluate pricing of the asset for each strategy, which can help traders make more informed decisions. It also indicated when to place a new hedge in the rolling intrinsic strategy, and when to buy or sell if the trader used a cash-only approach.
The author thanks Josh Gray for his contributions to this post.