A very interesting meat spread
22 April 2023
Dark clouds on the horizon
Dark clouds on the horizon
13 May 2023

Insights into the term structure

Over the past few weeks, I have received several e-mails asking me about the term structure. In this regard, I also invite you to watch a video I posted on my YouTube channel explaining the use of the term structure.

In this article, I show a practical example and take my cue from a chart that Pavel, CEO of SpreadCharts, posted on his Twitter account. The chart shows the term structure of natural gas with its 5- and 15-year averages.

What can be deduced from this chart is that the term structure is in its typical shape, with deliveries from January to April in a strong backwardation of about 10/15% due to sudden cold spells. If the cold goes on, backwardation will continue, otherwise, contango will return.

However, when compared to the 5- and 15-year averages, the shape is different. This is due to the sharp rise in natural gas which occurred shortly after the outbreak of the war in Ukraine and which greatly influenced the averages, especially the 5-year average. Therefore, comparison with the averages is of little value in this case. Below you can see the chart of the term structure in May 2019, four years ago.

Natural gas term structure 4 years ago (SpreadCharts.com)

Here, the two averages are devoid of 'particular' years that influence their shape. You have confirmation that especially the current 5-year average has little value (the 15-year average was less influenced). Another very important aspect that the term structure tells us is that yes, it is in its typical form but it is also much steeper than usual. This is obvious if I take the term structure for several years as in the chart below (up to 2035).

Natural gas term structure up to 2035 (SpreadCharts.com)

Except for the first two years or so, the term structure practically moves horizontally, repeating itself from year to year. This greater initial steepness is due to the return of natural gas prices to pre-war levels. In doing so, the closest deliveries (particularly the front month) have been the most oversold, bringing the term structure into an abnormally strong contango.

Once the term structure has been analysed, how can we turn the information obtained into trading? First of all, the analysis of a commodity or a spread is much broader. The study of the term structure is only one part of it, it alone is not sufficient to give a signal. However, it can provide the cue for a possible trade.

In this case, the very anomaly of the strong initial contango leads me to consider the NGZ23-NGZ24 spread interesting to buy. This is because the two deliveries are usually priced at about the same price and the spread, as you can see from the chart below, straddles zero.

NGZ23-NGZ24 Seasonality stacked (SpreadCharts.com)

Highlighted in the chart is the -0.5/+0.5 zone and this is the target zone for my operation. Even more evident if I take a longer chart (below, that of the last 5 years).

NGZ23-NGZ24 Seasonality stacked last 5 years (SpreadCharts.com)

You will also have noticed that the current spread is well below all the previous 9 years. This, in my opinion, has little value as if I take the Continuous histogram, over the last 31 years the spread price is not so extreme. However, there is confirmation of what we have seen with the stacked chart, the 25th-75th percentile range is between -0.3 and 0.3 (i.e., in that range the spread has spent 50% of the last 31 years).

NGZ23-NGZ24 Continuous histogram (SpreadCharts.com)

I will stop here with the analysis. The purpose of the article is to explain the term structure a little more in-depth and how to use it in the analysis. I hope it will be clearer now.

To complete the article, I show you the term structure of the feeder cattle from a few days ago, which was sent to me by Valeria in one of the e-mails received.

Feeder cattle term structure (SpreadCharts.com)

As I answered, it is very clear how steep the term structure is between the front month (May) and the August delivery (the next one), while thereafter it flattens out. This indicates that we will most likely see an increase in volatility on the feeder cattle, with the price I expect to return to the $210 area and the term structure to a normal and more correct tilt (if there are no outbreaks or other external factors).

In this case, one spread that was interesting (to sell) was GFQ23-GFX23. That is, if the rest of the analysis agreed.

I conclude by saying that when the term structure shows us more or less marked anomalies, a possible trade oriented towards a return to normality is beyond the scope of seasonality, which, even though it is against the operation, is of little value.

Over the past few weeks, I have received several e-mails asking me about the term structure. In this article, I show a practical example and take my cue from a chart that Pavel, CEO of SpreadCharts, posted

David Carli
David Carli
David is a financial analyst with over 29 years of experience (two years as a fund manager) in currencies and commodities. He collaborates with a major European commodity investment company and is the author of several successful books about trading and financial markets.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.