Brokers Say Funds Not to Blame for High Prices, Provide Benefit to Market
Some large gas consumers have placed the blame for current high natural gas futures prices and market volatility on speculative fund trading, but according to two veteran brokers without the funds in the market currently gas futures prices probably would go up even more.
It is wrong to blame the funds, the speculative non-commercial traders in the futures market, Tom Saal of Miami-based Commercial Brokerage said last week in a presentation at the "Managing Natural Gas Price Risk Workshop" at Nymex, which was sponsored by NGI. "The funds are currently net short natural gas, according to the latest Commitments of Traders Report. If you want the funds out of natural gas futures, you had better be careful what you wish for... If they were to get out of the market right now, prices could go up," he said.
According to the COT report released Friday, non-commercial traders were net short 33,289 positions as of Dec. 7, up from the 20,096 short positions held just a week prior.
The main criticism of the funds is that they have increased price volatility in natural gas futures because of their growing involvement and different trading methods from the commercial crowd, but Saal disagrees. "The speculators have been steadily decreasing their positions as a percentage of total open interest" this year, he said, pointing to the decrease from 17% of total open interest in May to just 9% in the latest COT report. "During that period, implied volatility has increased.
"Non-commercial fund traders add liquidity by increasing the amount of traders who can take the other side of commercial traders' bids and offers," said Saal. "The more non-commercial or speculative hedge fund traders participating in natural gas futures, the narrower the bid-ask spread. They provide necessary and beneficial liquidity."
However, it is possible, added Commercial Brokerage's Ed Kennedy, that the erroneous pre-Thanksgiving storage report (a 49 Bcf withdrawal corrected a week later by the EIA to a 17 Bcf withdrawal) created a situation that may have caught at least one non-commercial on the short side of the market (see NGI, Dec. 6). "But it is clear who the loser is in this instance. [The fund] was probably betting on a bearish number. When it came in bullish and the market rallied, they were forced to cover... They probably lost a fortune," Kennedy speculated.
Under normal circumstances, the main types of traders with open positions on the final day of trading are end users, producers and maybe pipelines, he said. "The liquidity in the futures market typically dries up in the last 30 minutes of trading as the open interest in the expiring contract approaches zero. In fact, [usually] the only outstanding positions are those traders willing to make or take delivery at the prevailing price level."
Kennedy and Saal explained that there are three main types of fund traders. One type is the inflationary fund traders, who buy natural gas as part of their basket of commodities, which act as a hedge against inflation. Another type is the "black box" speculators that buy and sell purely on a predefined set of computer-generated signals and technical indicators. The third type of non-commercial speculator is the discretionary fund trader, or day trader who bases their trading decisions on a myriad of factors, including possibly fundamental data, such as storage or weather. It is this latter type of fund trader that probably got caught short on Nov. 24 and was forced to pay up before the contract expired, Kennedy said.
"It may appear that the open-outcry futures trading pit at Nymex is nothing more than organized insanity," said Kennedy. "It's not. It's actually a very efficient mechanism for price discovery."
But if greater oversight of fund participation in the market won't help lower prices or dampen market volatility, then what can be done about that? One possible solution, Saal said, would be for state regulators to relax restrictions on utility hedging programs. "Go to your regulators and tell them to allow you to spread your hedges across a greater period of time than just the last-day settle," Saal said in response to an attendee query at the workshop.
Improving the quality of gas storage data also might be a good idea. "I would endorse anything that reveals better market data," said Kennedy, adding that stiff penalties should be levied on companies found responsible for inaccurate storage reporting.
It also is interesting that the Commodity Futures Trading Commission -- unlike the EIA -- waited until after the holiday weekend to release its weekly data report, noted Saal.