Natural gas market is a very volatile one: volatility is five times those recorded in many equity markets. Natural gas can be traded in an outright form or through spreads. These can be done buying spot or futures, even though most trading takes the form of futures or forward contracts. When taking a long position in futures (buying a position in gas) traders bet on a rise price, whereas a short position (selling a position in natural gas) involves a bet on decreasing prices. Both positions imply an exposure to a commodity for a certain period of time. To lengthen the exposure period, traders buy/sell strips instead of one single contract. A strip is a set of consecutive future contracts. The summer strip consists of all contracts from November to March and the summer strip is composed of contracts from April to October. Traders can take a view on the behaviour of the winter behaviour of natural gas prices by going long/short the winter strip. Instead of taking outright positions (net long or net short positions), a more common modus operandi in natural gas trading is through spreads. Spread trading involves a simultaneous long and short position of two futures (or strips). In natural gas spread, trading tries to catch or predict the price differences in two delivery periods (long the winter strip and short the summer strip, expecting price spikes in the winter period) or locations (long gas for delivery in Henry Hub versus New York Hub short gas futures for delivery, predicting problems for delivery in this last hub) .
This last year the natural gas winter strip for delivery in Henry Hub was trading at a premium of around 3 dollars over the summer strip (or put it differently, the winter/summer strip spread was trading at 3 dollars). In late August this spread narrowed and even became negative (with the winter strip trading below the summer strip). Several factors could explain this unexpected reversal: a) high stocks of natural gas; b) an almost nonexistent hurricane season and, c) predictions of mild winter that have been fulfilled. This development of events led to Amaranths debacle as well as to the Centaurus’ extraordinary performance. Whereas Amaranth loaded long positions in the winter’s strip over the summer, Centaurus was doing the opposite, being the other side of Amaranths trade. The end result was multibillions losses for Amaranth and spectaculars returns for Centaurus. The latter fund reported 150 % return last year and his natural gas trade has been named the top earning trade of the year.
The price behaviour of the winter and summer natural gas strips in 2006 and the reversal of their prices was probably a very small probability event. Just as the winter recorded this year was the mildest over fourteen years, this made the convergence of the summer and winter strip prices a close to 5 % probability event that led to abnormal losses and gains. One more lesson for risk management.