This week’s trade has been all about the spread between natural gas and crude oil. Using inter-market analysis allows us to compare the value of substitute goods. In this case, we can compare the price of crude oil to the price of natural gas to determine what price levels it becomes cost efficient for the markets’ participants to shift their energy needs from crude oil to natural gas and vice versa. The key to this type of analysis is using the proper pricing methodology. The calculation of the crude oil vs. natural gas spread is done using a ratio spread. Dividing the price of natural gas, currently around $4 per million metric BTU’s into the price of a barrel of crude oil at $77 gives us a ratio of 19.25. This ratio peaked at an all time high of 22.7 in April of this year. A spread ratio closer to 12 would represent an average relationship over the last few years.
The trick to trading this ratio is to try and create equal dollar movement in both contracts. We want the trade’s profit or loss to be accurately reflected by the ratio’s movement. If we were to simply do a one to one spread, buying natural gas and selling crude oil, we would end up with an imbalance on the side of the trade that has the largest daily dollar movement.
This problem is solved by using the average daily range multiplied by the market’s point value to provide us with the average daily dollar fluctuation of the individual markets. Crude oil’s nine day average range is exactly $2 per barrel. There are two sizes of crude oil contracts, the full size and the half size. The full size is $1 per point, which means an average daily range of $2,000. The half size obviously yields an average daily cash fluctuation of $1,000. The natural gas market has an nine day average range of .1563. This market also has two contract sizes. The full size contract which, has a daily cash fluctuation of $1,563 and a quarter size mini contract which, fluctuates about $390 per day.
Now, we have the pieces to construct a trade that is dollar value neutral and will accurately reflect our natural gas to crude oil ratio spread. Ideally, we would sell one full size crude oil contract with a daily fluctuation of $2,000 and buy one full size natural gas contract with a fluctuation of $1,563 plus an additional purchase of one mini natural gas with a daily fluctuation of $390. This gives us an average of $2,000 daily movement in the crude oil and $1,953 daily fluctuation in the natural gas.
More information on crude oil and natural gas can be found at NY Energy Futures.com
This type of ratio spread can also be used in grain markets when trying to spread corn or wheat against beans or even the corn to cattle spread. Please call with any questions regarding this trade or, spread trading in general.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.
Gee i like that kind of talk.