Trade the Crude Oil and Natural Gas spread to limit price risk.
Energy commodities are a volatile bunch. Amid a complex backdrop of the Russian-Ukraine conflict, a summer filled with heat waves and macroeconomic headlines, energy prices can swing in both directions quickly.
From a risk management point of view, one way to maintain exposure in the energy market whilst limiting directional/market risk is to trade a spread between two energy commodities. We can measure the spread of the WTI Crude Oil (CL) vs Natural Gas (NG) by dividing the prices of CL1! / NG1! . This ratio/spread provides us with an overview of the long-term relationship between the two products.
Over the past month, the pullback in WTI Crude Oil prices has presented an opportunity in the CL-NG spread. Generally, the spread exhibits a short/medium-term mean-reverting behavior and this behavior is premised on a few factors.
1) There is some level of substitutability between the two products as a form of fuel, therefore higher prices may drive consumers to use one over the other.
2) Most oil producers also produce natural gas, thus rising prices may incentivize them to drill for one product over the other.
3) Used as a form of relative value measurement for energy cost. When the spread trades at a high, we know that oil is likely trading rich relative to natural gas, and vice versa.
Currently, the spread is sitting right above the 10.5 level which has acted as a resistance level since 2018, except for the oil price crash during the pandemic. Revisiting the past 3 times when this level was breached, a long CL and short NG strategy proved favorable as the spread rebounded. The average length taken for the spread to reach the high is 3-5 months.
Should this relationship hold, we can long the spread by buying 1 WTI Crude Oil Sep 2022 future contract (CLU2022) and shorting 1 Henry Hub Natural Gas Sep 2022 future contract (NGU2022). However, do note that the contract value of the CL futures is ~ $97,000 while that of the NG futures is ~$80,000, so there is some exposure that is not fully hedged.
Spread Entry at 12.30, stops at 10.50. Targets at 17.80.
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios.
Reference:
cmegroup.com/education/articles-and-reports/are-crude-oil-natural-gas-prices-linked.html
From a risk management point of view, one way to maintain exposure in the energy market whilst limiting directional/market risk is to trade a spread between two energy commodities. We can measure the spread of the WTI Crude Oil (CL) vs Natural Gas (NG) by dividing the prices of CL1! / NG1! . This ratio/spread provides us with an overview of the long-term relationship between the two products.
Over the past month, the pullback in WTI Crude Oil prices has presented an opportunity in the CL-NG spread. Generally, the spread exhibits a short/medium-term mean-reverting behavior and this behavior is premised on a few factors.
1) There is some level of substitutability between the two products as a form of fuel, therefore higher prices may drive consumers to use one over the other.
2) Most oil producers also produce natural gas, thus rising prices may incentivize them to drill for one product over the other.
3) Used as a form of relative value measurement for energy cost. When the spread trades at a high, we know that oil is likely trading rich relative to natural gas, and vice versa.
Currently, the spread is sitting right above the 10.5 level which has acted as a resistance level since 2018, except for the oil price crash during the pandemic. Revisiting the past 3 times when this level was breached, a long CL and short NG strategy proved favorable as the spread rebounded. The average length taken for the spread to reach the high is 3-5 months.
Should this relationship hold, we can long the spread by buying 1 WTI Crude Oil Sep 2022 future contract (CLU2022) and shorting 1 Henry Hub Natural Gas Sep 2022 future contract (NGU2022). However, do note that the contract value of the CL futures is ~ $97,000 while that of the NG futures is ~$80,000, so there is some exposure that is not fully hedged.
Spread Entry at 12.30, stops at 10.50. Targets at 17.80.
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios.
Reference:
cmegroup.com/education/articles-and-reports/are-crude-oil-natural-gas-prices-linked.html
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