OPEC: Monthly Oil Market Report on 13 September 2021
13 September 2021
Weekly Petroleum Status Report on 15 September 2021
15 September 2021

A multi-leg spread on natural gas

The spread I am going to analyse is another one of the spreads I particularly love, even though it is a little more complex in form, being a Butterfly. The Butterfly is a complex spread, built on three different legs; these three legs form the Butterfly's body and wings. The Butterfly Spread combines a near-term bull spread and a longer-term bear spread (or vice versa if sold). This means that we buy two different months and then sell one month twice.

We use a Butterfly Spread because we believe that mid-term futures prices are going down and we expect an increase or, at the very least, certain stability in short- and long-term futures yields. These oscillations in the term structure fall into the normal seasonal behaviour of some commodities and can occur both in a contango market and in backwardation.

With a Butterfly, we create a differential between two different correlated spreads, which takes individual outright direction out of the trade. So, we speculate about the changes in the term structure, rather than on the underlying movements.

After this brief explanation, I begin to analyse the Butterfly on natural gas, more precisely the NGJ22-2*NGK22+NGM22 spread. I begin by showing you the term structure.

Natural gas term structure

Natural gas term structure (SpreadCharts.com)

The Butterfly seeks to exploit a peculiarity of the natural gas term structure. In February/April there is a strong backwardation, of about 10/15% due to sudden cold waves. If the cold goes on, backwardation will continue, otherwise, contango will return and that is what the spread tries to exploit.

In the chart above you can see in blue the current term structure, in grey that of a month ago and in green the 15-year average. What I get from the chart is that over the last month the backwardation has increased. As for my spread, the distance between the April and May deliveries (backwardation) has increased, while the distance between the May and June deliveries (contango) has remained unchanged. This, without needing to see the chart of the spread, makes me immediately understand that in the last month (at least) the spread has risen.

Also interesting is the comparison with the 15-year average, which at this point in the year shows the May delivery already in contango. The much flatter term structure in the first deliveries compared to the average confirms to me that natural gas has, or has had until recently, a bullish trend.

At this point, I go to check the price chart and look at it along with the COT net position of natural gas.

Natural gas price and net position

Natural gas price chart and COT net position (SpreadCharts.com)

What I can gather from the two charts is that the price of natural gas has risen to a level not seen since 2014. However, the strong price movement in recent months has not been accompanied by purchases by Non-Commercial or Large Traders (Speculator). This could mean that the rise is not due to speculation but has a solid foundation. Therefore, I am going to make a fundamental analysis of natural gas.

The global market is experiencing a classic but violent price cycle, with an unprecedented downturn in 2020, caused by the coronavirus epidemic and lockdowns, creating the conditions for a boom in 2021/22. The result was a sharp cutback in drilling and capital investment across the industry, leading to an unprecedented decline in worldwide output, which has remained depressed even as global economic activity has surged back.

In an inevitable reaction, prices have now climbed to their highest in real terms since mid-2014, as traders anticipate there will not be enough production to meet all the demand from consumers by the end of the year. Rising prices are sending a strong signal to the industry of the need to boost production and are providing the cash flow to finance a major increase in output, which should support strong growth in 2022 and 2023.

Higher prices will progressively incentivise more drilling and production, which should return the market to balance by the end of 2022, with prices retreating closer to long-term average levels.

In the same way, gas production fell much more quickly than consumption in 2020 to whittle down excess inventories, it will have to grow faster than consumption in 2022 to rebuild stocks to a more comfortable level.

Rebalancing the market will therefore require a period of unusually high prices in the short term before they revert closer to long-term average levels late in the second half of 2022 and into 2023.

So, it is very likely that the price of natural gas will continue to rise in the coming weeks. I am now going to look at the spread chart in a little more detail.

NGJ22-2NGK22+NGM22 daily chart

NGJ22-2NGK22+NGM22 daily chart (SpreadCharts.com)

The spread is a Butterfly on natural gas, and exactly NGJ22-2*NGK22+NGM22, the seasonal window goes from October to February (as highlighted in red in the chart) and has a bearish seasonality (so I have to sell the spread).

As I had guessed from the term structure, the spread has been in a bullish trend over the past month. The two seasonal patterns at 5- and 15-year are well correlated throughout the seasonal window. The 5-year seasonal pattern has deeper movements due to the fact that, with so few years, each has much more influence on its development/shape than the 15-year seasonal pattern.

I continue my analysis by looking at the current price level of the spread compared to the past and I do this by looking at two charts. The first is the Seasonality stacked.

NGJ22-2NGK22+NGM22 Seasonality stacked

NGJ22-2NGK22+NGM22 Seasonality stacked (SpreadCharts.com)

You can easily see that the spread is much higher than in previous years. Given the fundamental analysis it would not be bad if it reached the 0.25 area in the coming weeks. However, for the same reason, it is not to be sold now. The second chart I am interested in looking at is the Continuous histogram.

NGJ22-2NGK22+NGM22 Continuous histogram

NGJ22-2NGK22+NGM22 Continuous histogram (SpreadCharts.com)

I have taken the chart of the last 20 years even though, in some ways, it can be seen as useless since the years 2005-2008 condition the contango a lot, however, it would be even more so the chart of the last 5 years since with the Seasonality stacked chart, I have already ascertained that in the last 10 years the maximum price has just exceeded 0.25.

Here you can see which are the columns that act as price attractors (the highest ones) and which can be taken as targets for a bearish operation of the spread (0.00/0.07).

At the end of this analysis my considerations. The spread is very attractive but given the natural gas situation, I find it early to sell as the price is likely to continue to rise for a few weeks, in accordance with fundamental analysis.  The rise in the price of natural gas has not been generated by Large Traders, with a COT net position well away from the late 2016-end 2018 values with a futures price lower than today.

The rest of the analysis agrees with the bearish seasonality of the spread which has had 20 winning years in the last 20 years. Spread to be monitored patiently waiting for the time to sell it.


The spread I am going to analyse is another one of the spreads I particularly love, even though it is a little more complex in form, being a Butterfly. The Butterfly is a complex spread, built on three different legs

David is a trader with over 25 years of experience (two years as a fund manager) in currencies and commodities. He collaborates with a major European commodity investment company, and he is the author of several successful books about trading and financial markets.

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