Speculative Traders Gaining More Control of Natural Gas Futures
Despite claims to the contrary, the influence of non-commercial trading in the gas futures market is growing rapidly and the industry will have to adapt, said Tom Lord, president of Volatility Managers LLC. The question of how it will adapt is not easy to answer, but the process is likely to be painful for most, and could include an exodus of industrial customers seeking shelter in countries with regulated markets.
Right now the very large bet the non-commercials are putting on prices going lower with their large net short position, is worrying Lord and others. If there were a "weather event" and prices go up, as so often happens in the winter, the non-commercials would have to quickly cover their positions and they could accelerate the price movement, sending prices soaring.
Non-commercial traders as of Jan. 3 hold 43,663 net short positions. On only two other occasions has the non-commercial segment held a larger net short position. During November 2003, non-commercial traders held a peak net short futures position of 52,684. The record was set in January 2002, when non-commercials held a peak net short futures position of 62,643. This leads some to suggest that the market possesses a great deal of pent-up potential buying power.
"The market was being sold originally as a way for people to hedge. The problem is hedging is becoming as big of a business risk as not hedging, and that's your number one issue," said Lord, who has 20 years of experience advising energy companies and large gas consumers. "Nymex is not designed as a hedging market. The exchange is designed to be a trading market. The more the traders want to be in the market, the happier Nymex is."
In an effort to dispel criticism, Nymex said in late December that it will release a special report in January showing that hedge funds represented less than 10% of the natural gas futures trading volume this year between January and Aug. 31. But according to Lord, it's the percentage of open interest held by all non-commercial traders, (i.e. traders with no part in the physical gas market) that's more important.
"It keeps being said that non-commercials are a small percentage of the trading volume," the veteran risk manager told NGI. "However, they have a significant share of open interest, which is what really moves the market."
From 1995 to 2001, there were only two instances where the concentration of trades in the market in the non-commercial sector exceeded 30% of the open interest, Lord said. Using Commodity Futures Trading Commission data, he pointed out that March 2000 had the lowest participation by non-commercials in the history of the natural gas market with just under 10% of the open interest. "We have seen that grow, coming very close to hitting 50% in July 2004. Prior to that, in a two-week period, non-commercials went from 25% to 38%, then back to 25%."
Since March of 2003, the market has had a record concentration of open interest in the non-commercials. "I am not arguing that hedge funds are the only reason that natural gas is so unstable," Lord noted. "In fact I would argue that gas is becoming more and more unstable and beginning to look more like the electricity market, which is systemically unstable as opposed to [the gas market], which has been only episodically unstable.
"There are a lot of solutions out there, none of which provide, in my mind, any comfort to the large industrial, the large producer or the utility."
He said the biggest difference since 2002 is the fact that the price ranges have gotten a lot bigger. Industrials can deal with 50% front month volatility if prices are between $3.50 and $4.00, but what if gas prices are $7?
"At $4.00, energy might be 10% of my business," he said. "If it goes to $3.00, that's a 25% drop, but it's 2.5% competitive disadvantage. If we are bouncing between $3.50 and $4.50 and I buy $4, I could lose maybe 1-2% on my competitive position. Hedging in this market, I can live with a 1-2% competitive risk.
"Now I am at $7 and I've got a chance to go to $4 or $10. If I go from $7 to $4, I am now 7% or 8% higher on my overall operating costs than my competitor. Basically, what you are telling people is by being exposed to wholesale market prices, the number one impact on their earnings per share could be their hedging program."
Lord also pointed to other market changes brought on by the presence of more speculators. Commodity markets are supposed to be self-dampening. If prices are coming down, then there should be greater buying pressure. "The problem," Lord said, "is that the non-commercials tend to trend trade, which is an equity market term, not a hedging market term."
When non-commercials have 10-15% of the market, they don't have "a lot of bullets" at their disposal. "In that instance, the pressure of the hedging community overwhelms the pressure of the speculative community," he said. "However, when non-commercials have 50% open interest on the market, I don't have enough sellers to overwhelm the speculative buying. That does not mean that this is wrong.
"Trading markets in general are designed to make money for traders, not hedgers. However, because of this, I honestly believe we will start to see these large energy-consuming entities moving to countries that have regulated rates."
If the non-commercials are 50% of the open interest, Lord said one of two things can happen. "Either they will get squeezed and there will be a big run in price to one direction, resulting in someone getting hurt, or if it starts to go in the non-commercials' direction, they will just stand back and let everyone sell into them. They want big moves," Lord said, adding that "they don't trade for nickels or dimes."
As to how to solve the current issues surrounding the natural gas futures market, Lord said fixes used to be simple. "You would have position limits." Back when there were only a few large commodity funds, position limits restricted them to 15-20% of the market. "Now you have 100 funds and they all trade trends.
"I can't see how you get the funds curtailed because you do not want them out of the market entirely, but I am not sure position limits work," Lord said. "The only way you're going to get this market stabilized is the same way the electricity market did it, by getting it over-invested. You're either going to drive enough demand out to get it oversupplied, or you're going to drive enough investment into supply."
Lord said the saving grace for the natural gas futures market might be significantly more liquefied natural gas in the United States, because then natural gas futures would be a world market and would draw a number of international players.
"The one thing that the funds like about the natural gas market is that they are big players within it. They can run it," he said.
He noted the shift in trading has put the market into in an entirely different regime. "We are probably in a new paradigm," Lord said, one that is more volatile and unpredictable.
"I am not convinced that the hedge funds and the participation levels they are at today are something that reduces volatility. I am not sure they increase liquidity because it appears that they tend to trend trade. Hedge funds provide greater conditions for hyper-volatility." These conditions may be here to stay for a while.
In addition to being president of Volatility Managers LLC, Lord also serves as a managing partner for DEFG LLC and is an advisor to a private fund for acquisition of merchant power generation assets. Previously, Lord had sole responsibility for executing Morgan Stanley's physical trading activities in the United States, activities that exceeded 1 Bcf/d of flowing gas. Lord will be giving a presentation at GasMart in March in New Orleans. For more information on the conference go to http://www.gasmart.com/.