What are Natural Gas Futures and How To Trade In Them?
Natural gas is widely used in power plants for combustion turbines to generate electricity. It is also used as a heating fuel. As the energy demand in the world grows, natural gas is now considered a bridge fuel to overcome the use of coal. By 2025, the price of natural gas is expected to be 3.5 million USD per million BTU in the USA compared to 2.4 million USD in 2024.
Natural gas is widely traded in Northern Europe and the United States. Multiple global factors, such as supply-demand, weather conditions, and production capacity, determine the price movements of natural gas. Compared to international benchmarks, natural gas trading in India occurs with a smaller contract size. Due to logistic challenges, natural gas futures are not physically delivered, and all contracts are settled in cash. Let’s understand how natural gas trading in India takes place and how investors can diversify their portfolios by investing in this commodity.
What are Natural Gas Mini Contracts?
Natural gas trading lets you speculate on natural gas future prices by purchasing futures contracts. Natural gas is traded on MCX in India, similarly to crude oil. In India, options trading in natural gas was introduced in 2022, and within the first two months, the traded volume reached 4,4,000 contracts. The contract specifications for natural gas futures are given below:
|
Parameters |
Natural Gas |
|
Underlying |
Natural Gas Futures MCX |
|
Expiry Day |
2 business days before the expiry of the underlying futures contract |
|
(Last Trading Day) |
|
|
Underlying Quotation / Base Value |
Rs/mmBtu |
|
Strikes |
30 ITM -1 NTM -30 OTM |
|
Strike Price Intervals |
Rs 5 |
|
Tick Size |
Rs 0.05 |
|
(Minimum Price Movement) |
|
|
Daily Price Limit |
The upper and lower price bands are determined using statistical methods using the Black76 option pricing model and relaxed considering the movement in the underlying futures contract. |
|
Settlement |
On expiry of the options contract, the open position devolves into an underlying futures position as follows:
|
On MCX, you can trade natural gas Mini contracts, a smaller version of the regular futures contracts. They have smaller lot sizes, starting at 250 mmBtu. For the Mini contract, the tick size is Rs 0.10. So, a price movement of Re 1 in the natural gas Mini contact (one lot) can result in a tangible profit or loss of Rs 250.
The option chain for Natural Gas Mini September 2024 contracts on MCX is as follows:
The option chain for Natural Gas November 2024 contracts on MCX is as follows:
How Natural Gas Mini Contracts Work
The natural gas Mini contracts work similarly to futures contracts. You can take long or short positions by buying or selling the contracts. To take a position in the contract, you must deposit a margin amount relative to the size of the lot and the volume you wish to control. With natural gas futures, the margin amount also changes based on the inherent volatility of the commodity. Because of the highly volatile nature of natural gas prices, investors can profit from small changes in trading prices. Some of the benefits of natural gas futures investing are given below.
- Lower margin requirement - The natural gas mini contracts are smaller in size compared to regular contracts. So, the margin requirements are lower. Instead of investing a large amount in trading natural gas, you can control a substantial portion of the commodity using margin investment.
- Trading flexibility - You can customize natural gas futures contracts based on your risk management strategy. The smaller lot sizes allow greater flexibility for the position, making it easier for investors to manage their futures portfolios.
- Partial position exit - The natural gas Mini contracts have flexible exit options for investors. If you want to exit your position partially or book profit early, you can do so with the natural gas Mini contract. For instance, if a trader holds a position of 800 mmBtu of Natural Gas Mini, the trader can exit 300 mmBtu and maintain a position of 500 mmBtu. This level of flexibility is not possible with standard contracts.
Natural Gas Futures Vs Regular Futures: The Differences
While natural gas futures and futures on other assets share some fundamental characteristics, there are significant differences due to the unique nature of the underlying commodity. The following table highlights the differences:
|
Feature |
Natural Gas Futures |
Other Asset Futures (Equity, Commodity, Currency, etc.) |
|
Underlying Asset |
Natural gas is a physical commodity with storage and transportation challenges |
Various assets like stocks, commodities (gold, oil), and currencies are easier to manage |
|
Price Drivers |
Weather conditions, supply and demand, geopolitical factors, economic growth, storage levels |
Company performance, economic indicators, interest rates, geopolitical events, supply and demand |
|
Seasonality |
Significant seasonal price fluctuations due to heating and cooling demands |
Less pronounced seasonality, except for some commodities like agricultural products |
|
Contract Specifications |
Specific to natural gas, including delivery point, heating value, and quality standards |
Vary based on the underlying asset, with standardised contract terms |
|
Regulatory Environment |
Subject to energy-specific regulations, including environmental and transportation rules |
Regulated by financial markets and commodity exchanges, with specific rules for each asset class |
|
Risk Factors |
Weather-related risks, supply disruptions, geopolitical tensions, price volatility |
Market risk, credit risk, liquidity risk, operational risk |
|
Trading Hours |
Often have extended trading hours due to global demand |
Trading hours typically align with the market hours of the underlying asset |
Factors Affecting Natural Gas Futures Prices
For any commodity, supply and demand influence the price dynamics. However, several global factors affect the prices of natural gas. These factors are as follows:
- Stored natural gas reserves - The government stores natural gas in its reserves to mitigate the price risk during times of lower productivity. As the natural gas reserve diminishes, the country must buy more, which can result in higher prices due to restricted availability.
- Global demand - In the last 10 years, the global demand for natural gas has steadily increased. While the US is the top consumer of natural gas, the emerging Asian markets also contribute to the increasing demand.
- Alternative fuel generation - Natural gas prices may decrease as new, greener alternatives to fossil fuels are developed. The price may also decline as the demand for fossil fuels like natural gas decreases. If governments dedicate infrastructure to produce alternate forms of energy, the demand for natural gas will decrease, thereby decreasing its price.
- Production variability - The public opposition to hydraulic fracturing or fracking may result in reduced natural gas extraction, boosting its price.
- Weather conditions - Hurricanes, storms, and other acute weather conditions can shut down natural gas production for several weeks. The cold weather may cause people to need more heat in their homes, driving the demand for natural gas.
Conclusion
Similar to any type of investment, futures trading also has several risks. Market volatility is one of the key risk factors that can affect natural gas pricing. Without stringent risk management protocols, the high volatility can result in substantial losses. Remember, natural gas futures are leveraged instruments. So, you may lose more than your initial investment based on the price movements. Learning the trading strategies, identifying your risk tolerance, and studying the market outlook can help diversify your portfolio with natural gas futures.