Reading the Term Structure of Futures Prices

Over the last few years, natural gas prices in the U.S. have been pounded by a variety of factors. Front and center are the continuing breakthroughs in horizontal drilling and hydraulic fracturing. On top of this, the winter of 2011-2012 was the fourth warmest on record, according to the National Oceanic Atmospheric Administration (NOAA), and those temperatures slashed demand. From a peak of over $13/mmBtu in July 2008, the price fell to almost $2/mmBtu in March 2012.

How much of the price drop has been due to which factors?

Of course, the answer to that question is anybody’s guess, and no one’s guess can be hazarded with too much certainty. But the term structure of futures prices is a good distillation of the opinions of many market participants. Anyone trying to comment on market movements would be well advised to be informed on how the whole term structure has shifted, and not just on how the spot price has moved.

The chart above shows the natural gas futures prices for delivery in three different months. The blue line is the price for delivery in April 2012. The red line is the price for delivery one year later, in April 2013. The green line is the price for delivery one more year later, in April 2014.

Back in late 2008,  the three prices lay on top of one another. All three were markedly below the spot price at the time. The three futures prices stayed close to one another for some time. In the 18 months from July 2008 through December 2009, the price of all three contracts fell nearly 40%. The drop was virtually identical across the three. That tells us that the factors driving down the price at the earliest of these three dates were not unique to any one of these three delivery dates, but were expected to impact all three years. In all likelihood, the price fall shown in those 18 months was due to lasting factors like the ongoing technological developments that are increasing the resource base that is available across all years.

However, in the 7 months from September 2011 through March 2012, the price for the April 2012 contract fell by 47%, but the price for the April 2014 contract fell less than half as much, only 24%. About ½ of the price drop in 2011-2012 is likely to have been due to short-term, transitory factors like the unseasonably warm weather. But not all of the price drop can be attributed to these transitory factors. The other ½ of the price drop in 2011-2012 appears to be due to more permanent factors, such as the ongoing technological developments making supply cheaper.

There are more formal modeling techniques for extracting this kind of information from the term structure, but this is the basic content regardless of the particular mathematical model employed.

One Comment

  1. Posted April 12, 2012 at 3:02 pm | Permalink

    The ETF GASZ is an attempt to profit from the contango. Likewise, you can short UNG and go long UNL.

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