Natural Gas: Background, History, and Extraction Process

Natural Gas 

Let us begin our exploration by covering aspects of background information, history and the extraction process of natural gas.

Natural gas is a naturally occurring mixture of hydrocarbon gases, primarily composed of methane. It is a non-renewable fossil fuel used for a variety of purposes in our daily lives: generating electricity, heating, and cooking; as well as its industrial applications in the fertilizer and plastic industries.

It is said that natural gas seeped from the ground on Mount Parnassus in Greece during 1000 B.C., and this resulted in a flame being lit.

It is believed that the Chinese had been aware of natural gas since around 500 B.C. They made use of this resource by setting up bamboo “pipelines” to move it when it surfaced and to use it in the process of boiling seawater to get drinkable water.

The Chinese discovered Natural Gas around 500 B.C., and they put this to better use – they started using bamboo “pipelines” to transport natural gas that seeped to the surface and to use it to boil seawater to get drinkable water.

The first utilization of natural gas for commercial purposes took place in Britain. As early as 1785, British citizens employed this form of coal-generated gas to light up their lighthouses and streets.

It’s obvious that Natural Gas is tucked away beneath the earth’s crust. The inquiry is how and why it is found in this spot?

Millions of years ago, plants and animals died, and their remains were gradually buried under sand and silt. Pressure and heat transformed them into coal, oil, and natural gas. In some places, it moved into the cracks between layers of rocks while elsewhere collecting on the surface of porous rock. Originally colourless, odourless and tasteless, natural gas poses a serious risk if it leaks unnoticed. To facilitate its detection in such circumstances, producers add mercaptan to it; this substance gives natural gas an unmistakable sulfuric aroma.

Geologists pinpoint land parcels that could contain natural gas. These locations can be either on the earth’s surface or offshore, beneath the ocean floor. Using seismic surveys, geologists find the best sites to drill and maximize their chances of success. Following this, an exploratory well is drilled if it appears promising economically; additional wells could then be drilled as needed to extract the natural gas.

India is the world’s seventh-largest producer of natural gas, making up around 2.5% of global production. This fuel is primarily utilised in power generation, industrial activities and liquefied petroleum gas (LPG). Additionally, a major portion goes towards the fertilizer sector as a raw material.

This conversation on Natural Gas – generation and utilization has the potential to become quite expansive, so let’s conclude our exploration here considering we are focusing on short-term trading involving Natural gas.

We will move ahead to discuss the contract specification.

However, no discussion on Natural gas is complete without talking about the ‘Amarant Natural Gas gamble’. 

– Amaranth Natural gas gamble

Established in 2000, Amaranth Advisors was a multi-strategy hedge fund based in Greenwich, Connecticut. The company had its fingers in many pies, engaging in everything from convertible bonds and merger arbitrage to leveraged assets and energy trading. It reached its peak at mid-2006 when it had amassed a $9 Billion portfolio – with profits reinvested into the fund. This propelled Amaranth to the top of the US hedge fund heap.

When Brain Hunter joined Amaranth’s trading team as its star trader, trading activity on the energy desk skyrocketed and he began to gain a lot of attention. He was already well-known in the sector from his previous role at Deutsche Bank, where he had made impressive profits through his trading strategies (particularly involving natural gas). Consequently, when he joined Amaranth to head their energy desk it was no surprise that Hunter continued to be successful; by April 2006, the firm had recorded almost $2 billion in profit from his knowledge and expertise. His skill impressed both clients and management alike.

At this point, it is important to note that even though natural gas was an international commodity, trading was highly susceptible. Any mid-sized hedge fund had the potential to control the market by getting their hands on a few thousand contracts, which is what made Amaranth one of the most prominent hedge funds in the natural gas scene.

Anyway, here is what happened post-April 2006 –

1.     Hunter noticed a surplus inventory of natural gas in the US, which would drive the price of natural gas lower in the US.
2.     Natural gas inventories are not as convertible as oil inventories, making it difficult to meet fluctuating demand.
3.     He foresaw a harsh winter (or possibly a hurricane) would have an effect on the supplies and likely cause the price of Natural gas to rise.
4.     Apparently, Hunter had gained from when hurricanes Katrina and Rita struck the US coastline in 2005.
5.     He constructed intricate tactics at multiple points across a number of contracts to take advantage of his extremely advantageous outlook. These were heavily leveraged, speculation futures positions.
6.     However, nature had something different in store for Hunter and Amaranth – the likelihood of a hurricane waned, while supplies kept coming in.
7.     The bulls began to step away, causing Natural Gas to dip beneath the $5.5 psychological barrier.
8.     The further triggering of panic meant that Natural gas price plummeted by 20% in one day.
9.     Amaranth was hit quite hard, but Hunter’s conviction and reputation were still intact. They now borrowed money and doubled down on their positions.
10. The leverage was as high as 1 to 8, meaning for every 1 USD of their own capital, they had 8 USD in borrowed capital.
11. This didn’t stop natural gas prices to tank. Further, prices continued to crash, and along with the price Amaranth too crashed.
12. Amaranth faced liquidation, suffering a loss of USD 6 Billion – one of the biggest collapses in the history of hedge funds.

A key takeaway from the Amaranth’s affair is the attribution of paramount importance to risk management. It should not be overlooked; it has the ultimate say on all dealings.

Treat risk with reverence and it will return the favor; however, if you disregard it, it will be sure to put you in your place.

Given this, we will commit the entire upcoming module to Risk and trading psychology.

For now, let us proceed to discuss the contract specs of Natural Gas.

 – Contract specifications

The contact specs for Natural Gas are as below –

o   Price Quote – Rupee per Million British Thermal Unit (mmBtu)

o   Lot size – 1250 mmBtu

o   Tick size – Rs. 0.10

o   P&L per tick – Rs. 125/-

o   Expiry – 25th of every month

o   Delivery units – 10,000 mmBtu

Here is the snap quote of the Natural gas expiring in Feb 2017 –

The price, as seen here, is Rs. 217.3 per mmBtu. Therefore the contract value would be –

Lot size * price

= 1250 * 217.3

= Rs. 271,625/-

The NRML margin is as shown below –

You can see that the NRML overnight margin stands at Rs. 40,644/-, one of the highest market margins at about 15%. And for MIS positions, the margin is Rs.20,322/- – approximately 7%.

Have a glance at the table beneath to see the straightforward logic employed for contract introduction and expiration

Every 4 months, a new contract is presented; for instance, the January 2017 one was released in October 2016 and ends on the 25th of that month.

It’s essential for you to understand that the spot price of Natural Gas in India is influenced by both the international market and domestic demand & supply. MCX’s futures contracts imitate the Natural Gas listed on NYMEX quite well.

Have a look at the image below –

The following graph displays the Natural Gas futures contract on MCX alongside NYMEX; their movements clearly demonstrate that they are closely correlated. Thus, any contextual shifts in the market have a major influence on the prices of Natural Gas futures on both platforms.

o   Natural Gas inventory data – an increase in inventory tends to lower the futures price and a decrease in inventory data tends to increase the futures price.

o   US weather conditions – US weather has a huge effect on the natural gas market, being one of the largest. An especially cold winter would cause more energy to be used for heating purposes and the supplies in inventory would quickly deplete, resulting in higher prices.

o   Hurricane in the US – When a hurricane approaches the US coast, it’s important to prepare for possible disruptions to weather patterns as well as inventories. Therefore, it is advisable to invest in Natural Gas or at least not go short on natural gas contracts.

o   The price of Crude oil – The price of natural gas is much lower than that of Crude oil, and it is not only a cleaner fuel, but the two contracts have typically had a strong correlation – though this has recently started to dissipate. Take a look!

When you are trading natural gas, make sure to look into the sun’s conditions in the US!

That concludes this Natural Gas chapter and this module about Currencies and commodities. It has been our pleasure to write it for you, we hope you enjoyed it!