A Mean Reversion Pair Trade From the Energy Pit: Long Natural Gas/Short Crude Oil - Please Act

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A Mean Reversion Pair Trade From the Energy Jewelers/Short Blue Nile
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At PAA Research our primary focus has always been on identifying outstanding Now
 Causality in the Natural Gas Pit - How the UNG
opportunities within the stock market. However, we do follow the commodity
Works in Theory (And Why it Doesn’t)
markets closely and from time to time we have successfully identified pair trades
between two commodities whose current price relationship has deviated
substantially from historical norms and are both dollar denominated. It is this Popular Posts
approach that lead us to establish a short position in gold in late February of this  Revisiting Our Mean Reversion Pair Trade from
year against a long position in crude oil (at the time gold was trading at 30x the the Energy Pit - Long Natural Gas/Short Crude
price of crude, several standard deviations above historical norms). Today, we Oil: We Still Like It
have identified what we think is an equally compelling trade: long natural  A Pair Trade with Some Sparkle - Long Signet
gas/short crude oil. Jewelers/Short Blue Nile
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A Brief Look at the Current State of the Natural Gas Market  Causality in the Natural Gas Pit - How the UNG
Works in Theory (And Why it Doesn't)
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Natural gas demand is largely contingent upon two factors: weather and
Pit: Long Natural Gas/Short Crude Oil
economic activity. It should not come as a surprise that natural gas has sold off
sharply from its highs a year ago. Over the past decade, natural gas prices
have spiked on three separate occasions: 1) the brown-out/energy trading Join Our Email List
debacle in California (thank you Enron) in 2000, 2) Hurricanes Katrina and Rita
in August/September of 2005, and 3) the oil induced price spike in the summer Your email:
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Market Quotes and Current Investment

Ideas

DJIA 8407.78  

-1.43%
As the chart demonstrates, natural gas now trades at 2002 levels. Natural gas
prices are down 40% since the start of the year and down more than 75% from

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A Mean Reversion Pair Trade From the Energy Pit: Long Natural Gas/Short Crude Oil - Please Act Acc... Page 2 of 5

the highs of 2008. Storage levels have been less than supportive of prices.
According to the EIA,  natural gas in storage was up 34% YOY to 1,823 billion
cubic feet. This puts storage at 22.5% above the five-year average. Industrial
production remains weak, NOAA has predicted a weaker hurricane season for NASDAQ 1827.01  
2009 and storage levels are about to eclipse five year highs. However, there
are a few reasons for optimism: 1) decline rates on unconventional natural gas
production remain high, there are signs that the economy could be bottoming,
-0.92%
and a huge amount of rigs have been “laid down”.  According to Baker Hughes
(BHI 36.29 ↓1.33%), the rig count has declined more than 50%, which would
certainly imply that a supply correction could be imminent. There were only
955 rigs in operation as of 4/24/09, a level of rig activity not seen since 2002.
Of all the reasons to become bullish on natural gas, we find its relative price to S&P 500 914.20  
light sweet crude the most compelling.

The Historical Relationship Between Crude Oil and Natural Gas Prices -1.41%

Over  the course of the past 100-years, natural gas and crude oil products have

been seen as close substitutes in the US. Industrial companies and utilities
switched between natural gas and crude oil products depending on the relative
price at the given time. This lead to a strong correlation between natural gas THQI 7.25  
prices (a domestic product) and crude oil prices (a global product). Over the
past 10-15 years, the number of facilities that are able to switch between natural
gas and petroleum products based generation has declined. According to the -2.29%
EIA,  approximately 18% of natural gas usage can be switched to petroleum
products and 15-20% of power generation is dual fired (able to use either
natural gas or crude oil).
ESI 101.85  
Historically, there have been several “rules of thumb” used to explain the price
relationship between natural gas and crude oil. A few years ago, the Dallas
Fed published a paper entitled “What Drives Natural Gas Prices?”, which can be +7.11%
found here.  The primary conclusion of the Dallas Fed is that the relationship
has deviated somewhat from some of the historical “rules of thumb”, but crude
oil prices still drive natural gas prices. Here’s an outline of some of the
historical “rules of thumb” that industry participants have used to explain the
ARP 8.40  
ratio of crude oil to natural gas prices.

1.  The 10:1 Rule - A simple explanation of the price ratio between crude oil

+0.84%
and natural gas, would imply a natural gas price of $5.10 today, given
crude oil’s closing price of $51. According to the Dallas Fed, this chart
explanation of prices held up reasonably well during the 1990’s.
2. The 6:1 Rule - This rule should really be called the “5.825 Rule” because
it is meant to express the price ratio between natural gas and crude oil in CLM09.NYM 59.65  
terms of their energy content. A barrel of crude contains 5.825 million btu
and natural gas futures are denominated per million btu. Based on this
rule, natural gas would trade at $8.75 based on a closing price of crude +0.00%
oil of $51. chart
3. Burner Tip Parity- The burner tip explanation of natural gas prices offers
a more nuanced approach to energy content. According to this model,
natural gas prices should be compared to that of residual fuel at the NGM09.NYM 3.54  
burner tip. Residual fuel oil has an energy content of 6.287 million btu
and residual fuel oil has typically traded at a 5% discount to WTI crude
oil.  This would imply a crude oil to natural gas price ratio of 7.09x.
+0.00%

Overall, none of these “rules of thumb” have served as a perfect proxy for
determining the appropriate natural gas price given a change in the price of
crude oil. However, they have served as reasonable guide posts over the past
ZIPR 2.65  
25-years. 

There is No Fundamental Justification for Crude Oil to Trade at More than

-7.02%
15x the Price of Natural Gas

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A Mean Reversion Pair Trade From the Energy Pit: Long Natural Gas/Short Crude Oil - Please Act Acc... Page 3 of 5

We have been following the price action in the commodities pits closely over the
past 2-3 months as leading or coincident indicators of an equity market rally.
The price of NYMEX crude oil bottomed on February 12th at $33.98 and has
since rallied more than 50%. At the same time, the price of natural gas has RGR 12.58  
declined from $4.49 on 2/12/09, to $3.37, a 24% decline. To summarize,
crude oil has outperformed natural gas by almost 75% over the past 10
weeks!  The price of crude now trades at more than 15x the price of natural
+2.53%
gas.  This will likely lead to a demand response from producers (who can
substitute crude oil production for natural gas) and consumers (utilities)who will
almost certainly switch as much power generation to natural gas sources. Not
since the late 1970’s/early1980’s has crude oil commanded such a sizeable
premium to natural gas. The following chart outlines the ratio of crude oil prices SWHC 5.67  
to that of natural gas since 1994 (the first year natural gas traded on NYMEX).

+2.53%

HURN 46.45  

-1.11%

BCO 29.05  

-0.51%

NILE 43.30  

A few things become clear upon reviewing the chart. First, the ratio of the price
of crude oil to that of natural gas has been far more volatile in the past 12-24 -0.02%
months than it has been over the past 15 years. Second, and in our view more
importantly, the price of crude has not traded at a 15x multiple of natural gas at
any point over the past 15 years.
SIG 20.39  
Here’s the most interesting part. There have been 7 instances over the past
15-years when crude oil traded at more than 12.5x the price of natural
gas.  Going long natural gas and short crude oil during those periods -2.02%
produced positive returns in every instance and returned 19.9% on 2009-06-30 13:55
average over a 3-month period and 22.5% on average over a 6-month
period.
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 Causality in the Natural Gas Pit - How the UNG Works in Theory (And
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This entry was written by PAA Research, posted on April 30, 2009 at 9:57 pm,
and filed under Commodities and tagged Crude Oil, Natural Gas, UNG, USO. For-profit Education
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