How the natural gas market works

A regional market, not a global one 

Oil can be put in a tanker and sold wherever it fetches the most, which is why there is broadly one oil price with local differentials around it. Gas cannot. In its natural state it occupies a volume hundreds of times greater than the equivalent energy in liquid form, so moving it requires either a pipeline built to a fixed destination or a chain of plants that chills it to a liquid, ships it in specialised vessels and turns it back into gas at the far end. Both are enormously capital intensive and neither can be redirected quickly.

The consequence is that gas prices are regional. A North American benchmark priced at a pipeline junction in Louisiana, a north west European benchmark priced at a virtual trading point in the Netherlands, and an Asian assessment for delivered liquefied cargoes can and do trade at prices that differ by multiples rather than by percentages, and they can move in opposite directions on the same day. The instrument carried in the catalog as Natural Gas references the North American benchmark, and it is a statement about that market rather than about gas everywhere.

Liquefied cargoes are the mechanism that partially links those regions, and the link works only when the price gap exceeds the full cost of liquefaction, shipping and regasification. Below that threshold the regions are effectively separate markets. Above it, cargoes are diverted toward the higher priced destination and the gap begins to close, which is why export terminal capacity and outages at those terminals are watched as closely as production itself.

The storage cycle that structures the year 

Gas production is close to constant through the year, because wells produce at whatever rate the reservoir and the infrastructure allow. Consumption is anything but constant: heating demand peaks in winter, power generation demand peaks in the hottest weeks of summer when air conditioning load is highest, and industrial demand runs steadily beneath both. The market reconciles a flat supply with a seasonal demand by storing gas, principally in depleted reservoirs and salt caverns, and the annual cycle of filling and emptying those stores is the frame everything else is read against.

The convention divides the year into an injection season running through the warmer months, when production exceeds consumption and the surplus is put into storage, and a withdrawal season through the colder months, when consumption exceeds production and the difference comes out of storage. The level of gas in storage at the end of each season, and how that level compares with the same week in previous years, is the standard measure of whether the market is tight or comfortable. Storage capacity is finite in both directions, and both limits bind: a market that fills its storage before the season ends has nowhere to put the surplus, and a market that empties it faces the coldest weeks with nothing in reserve.

What moves it 

Weather forecasts are the dominant short term input, and gas is unusual among traded markets in that the forecast rather than the outcome is what is priced. Meteorological models update several times a day, and the market reads them through degree day measures, which convert a temperature forecast into an estimate of heating or cooling demand. A revision in a model run that shifts expected demand over the coming fortnight moves the price immediately, and the physical consumption it anticipates has not yet happened.

The weekly storage report published by the United States energy statistics agency is the calendar's fixed point. It reports the change in gas held in underground storage for the week, and the convention is to read the figure against the range of analyst estimates and against the five year seasonal norm rather than in isolation. Production data, pipeline maintenance schedules, liquefied export terminal utilisation, and the relative cost of gas against coal in power generation are the slower inputs that set the level the weekly figure is judged against.

Gas is among the most volatile of the widely traded commodities, and the reason is structural rather than behavioural. Supply cannot be increased quickly, demand in a cold snap cannot be reduced at all, and storage is the only buffer between them. When that buffer is comfortable, a demand surprise is absorbed with little price movement. When it is thin, the same surprise has to be resolved entirely in price, because there is no quantity adjustment available on the timescale required.

Who trades it 

• Producers, selling forward output from wells that are already drilled, and often hedging a large share of expected production in order to fund the drilling programme.
• Utilities and power generators, buying forward the fuel they have committed to burn and hedging the difference between the cost of gas and the price of the electricity they will sell.
• Industrial consumers for whom gas is a feedstock rather than a fuel, notably fertiliser, chemical and glass manufacturers.
• Storage operators and marketers, whose business is precisely the seasonal spread between injecting gas in one season and withdrawing it in another.
• Financial participants, funds and speculators, providing the depth on the other side of those hedges.

The seasonal shape of the curve 

The natural gas futures curve is not a smooth line, and it is the clearest example in any commodity of a curve carrying a physical story. Winter delivery months trade at a premium to the surrounding autumn and spring months, because gas delivered in the coldest part of the year is worth more than gas delivered when nothing needs heating. That premium is what pays a storage operator to hold gas through the intervening months, and the spread between an autumn month and the following winter month is the direct market price of storage.

When it trades 

The contract trades electronically for most of the day, from the Sunday evening open through to the Friday close with a daily maintenance break, and the exact session is published per instrument in its specifications. The single most concentrated moment of the week is the storage release in the North American morning, and forecast model updates during the European night are a recurring source of movement while regional depth is at its thinnest. Gapping between the close and the reopen is more common here than in most markets, because a weekend of weather model runs is priced into the first trade.

How a CFD on natural gas settles 

A contract for difference on natural gas references the benchmark price and settles in cash. No gas is delivered and no storage obligation arises. Quotes are in US dollars per million British thermal units, which is an energy measure rather than a volume, and the difference between the opening and closing price is multiplied by the number of those units the contract covers. The unit price is small and the contract multiplier is large, which is the arithmetic that makes an apparently trivial price change a substantial money amount.

The final row is the point of the example. A price change that reads as a rounding error against a benchmark quoted in the thousands is a percentage move of a different order entirely on a commodity quoted in single digits, and the money result on a full contract reflects the percentage rather than the appearance. Profit and loss is calculated on the full notional value while only a percentage of it is posted as margin, so an adverse move is measured against the whole contract and a loss can exhaust the margin posted rather than being limited to it, with a favourable move measured identically.

Where the instrument is written on a dated futures month it inherits that month's last trading day, and is closed at the prevailing price or rolled into the following month on a date published in the specifications. Because the gas curve is strongly seasonal rather than smooth, the price of the following month can differ from the expiring one by a large amount, so the roll on this commodity is a more consequential event than it is on most, and it reflects the calendar rather than any view about direction.