Dr. Ken Rietz
Natural gas futures historically have been very volatile, and now is no exception, and the factors that cause this volatility come and go as well. In this commentary, we will look in some detail at the major factors driving volatility. But first, we look at the prices of the front-month futures of US natural gas.
Figure 1: Henry Hub/NYMEX front-month futures at closing
This might not look terribly volatile, but it actually is. The closing futures value changed by −14.3% from July 18 to July 24 (less than a week), less than a month ago. And the closing futures price dropped −6.91% from July 30 to Aug 5, (also in less than a week), in the immediate past. In general, however, the volatility of natural gas futures has been declining since the beginning of this year.
A large variety of factors contribute to the volatility of the price of natural gas futures, and energy futures in general. This is because consumers have little choice about the type of energy that they can use. Overall, the price is a matter of supply and demand, of course. Production, imports, and storage are the main supply factors, and they are tied to price. The higher the price of natural gas, the more that producers will pump and the more that will be pulled from storage. (The amount of natural gas that the US imports is a small fraction of what is produced.) The majority of the volatility in natural gas futures is generated by demand.
- Weather, specifically temperature extremes. Natural gas is used for heating in the winter and to generate electricity to run air conditioners in the summer. Additionally, very cold weather can cause natural gas production to decrease, reducing the amount of natural gas that is available. The cold snaps during the winter of 2002/2003 and February 2021, for example, caused the natural gas prices to spike dramatically, driving up volatility.
- Algorithmic trading. The fraction of trading in natural gas and other energy markets is substantial, and increasing. Trading computers scan every bit of news, analyze it, and trade based on the contents within seconds, rather than the hours that it used to take human traders. Big financial firms and hedge funds use algorithmic trading to get into positions as soon as possible, when there seems to be a good chance of a quick movement in price. This means that prices move much more rapidly than they used to, and this rapidity affects the volatility.
- Economic conditions. This one is pretty obvious. The more the economy produces, the more natural gas power will be needed to support that growth.
- The amount of Liquified Natural Gas (LNG) that is exported. The amount of LNG that gets sent over to, say, the EU, is also a drain on the amount of natural gas available in the US. The Department of Energy has published a report on the effect of LNG exports on US natural gas prices, and concludes that overall US prices will increase, but varying amounts depending on which scenario plays out. It does indicate that sufficient natural gas would remain in the US for its needs in any likely scenario.
- Geopolitics. Again, this is obvious. The Russian-Ukrainian war and the Israeli 12-day war with Iran are only the two most recent examples.
How can this help with hedging or trading? The volatility directly affects the value of futures. The amount of volatility will determine whether you want to sell or buy: Buy when the volatility is low, sell when the volatility is high. Since most hedging and trading operations can either buy or sell, that determines the most favorable form of the trade.