Natural Gas Options Explained

Natural Gas Options Explained

Natural Gas options are option contracts in which the underlying asset is a natural gas futures contract.

The holder of a natural gas option possesses the right (but not the obligation) to assume a long position (in the case of a call option) or a short position (in the case of a put option) in the underlying natural gas futures at the strike price.

This right will cease to exist when the option expire after market close on expiration date.

Natural Gas Option Exchanges

Natural Gas option contracts are available for trading at New York Mercantile Exchange (NYMEX).

NYMEX Natural Gas option prices are quoted in dollars and cents per mmBtu and their underlying futures are traded in lots of 10000 mmBtus of natural gas.

Call and Put Options

Options are divided into two classes – calls and puts. Natural Gas call options are purchased by traders who are bullish about natural gas prices. Traders who believe that natural gas prices will fall can buy natural gas put options instead.

Buying calls or puts is not the only way to trade options. Option selling is a popular strategy used by many professional option traders. More complex option trading strategies, also known as spreads, can also be constructed by simultaneously buying and selling options.

Natural Gas Options vs. Natural Gas Futures

Additional Leverage

Limit Potential Losses

As natural gas options only grant the right but not the obligation to assume the underlying natural gas futures position, potential losses are limited to only the premium paid to purchase the option.

Flexibility

Using options alone, or in combination with futures, a wide range of strategies can be implemented to cater to specific risk profile, investment time horizon, cost consideration and outlook on underlying volatility.

Time Decay

Options have a limited lifespan and are subjected to the effects of time decay. The value of a natural gas option, specifically the time value, gets eroded away as time passes. However, since trading is a zero sum game, time decay can be turned into an ally if one choose to be a seller of options instead of buying them.

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Understanding the Natural Gas Market: Part I: The Basics

This is the launch of the series on the natural gas market and is for anyone who wants to learn

This guest blog post is written by Vladimir Bezruchenko

ABOUT THE AUTHOR: Vladimir Bezruchenko is an independent trader based in Kiev, Ukraine. He has been actively trading from home since 2020. He specializes in US natural gas futures (NYMEX Henry Hub) and high-yielding commodity currencies.

The commodity natural gas is an energy commodity, a fossil fuel. Just like other forms of petroleum, natural gas is primarily used to generate power and drive things around us. It is therefore a vital commodity and has become increasingly important over the past years.

Types

Broadly speaking, natural gas can be divided into two categories: dry gas (almost pure methane) and wet gas (contains other hydrocarbon compounds, such as ethane, propane and butane). Dry natural gas is also known as consumer-grade natural gas and this is the type of gas this series will focus on.

It is important to note that wet gas and liquefied natural gas (LNG) are two completely different things. Wet gas is extracted from the depths of the earth, whereas LNG is simply a liquid form of dry gas that has been converted into that form by human-made technology.

Measures

Quantities of natural gas can be measured in two ways. One way is to measure the actual volume of the commodity itself. In this case, it is common to use normal cubic meters (cm) or standard cubic feet (cf). Another way is to measure the energy content of natural gas (the so-called “gross heat of combustion”) – i.e., the amount of energy released as heat when natural gas is burned. In this case, the most common measures are: joule (J), kilowatt hour (kwh) and British thermal units (Btu).

Below are approximate measurements and conversions for dry natural gas:

To put things into perspective, one Btu is approximately equal to the energy released by burning a single wooden kitchen match. So, burning one cubic meter of gas is equivalent to burning 36,409 wooden matches.

Natural gas pricing in the United States has moved from a volume-based pricing system to a heat-content pricing system. In other words, natural gas is bought and sold based on its BTU content, not on how many cubic feet it contains. That is why it is very important to understand the measurements in this market.

Demand

As an energy source, natural gas can be used in a variety of ways. It can heat homes and businesses, generate electricity, cook food, drive vehicles or serve as an industrial fuel. We can divide consumers into several categories:

• Population (residential consumption) – private dwellings, apartments.
• Businesses and non-manufacturing activities (commercial consumption) – hotels, restaurants, wholesale and retail stores, etc.
• Industry and manufacturing (industrial consumption) – chemical plants, mining and mineral extraction, etc.
• Power plants (electric power sector) – gas-fired power plants and utility companies in general, whose primary business is to sell electricity and/or heat to the public.
• Transportation (vehicle fuel consumption) – trucks, cars, container ships and other vehicles that run on natural gas.
• Other consumption (technical consumption) – include gas used in drilling operations, as a fuel in natural gas processing plants and gas used in the operation of pipelines.

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Supply

Natural gas can be found in various geological formations both onshore (for example, in the Rocky Mountains) and offshore (for example, in the Gulf of Mexico). Just like crude oil, natural gas is produced through basic deposit drilling and well system. However, natural gas deposits can have very different geological characteristics and therefore require different production techniques in order to extract it. The industry distinguishes between conventional and unconventional gas.

Conventional gas is trapped in various rock formations, such as carbonates and sandstones that have good porosity and permeability characteristics. It is easy, feasible and economic to produce.

Unconventional gas is more difficult and costly to produce, since it is found in places with more complex geological characteristics, such as coal beds and shale formations. However, recent technological breakthroughs have made unconventional gas supplies (particularly shale) commercially viable and completely changed the natural gas supply picture, especially in North America.

Storage

Producers accumulate natural gas in underground storage facilities for peak demand times. These storage inventories enable local distribution companies to avoid imbalances in the marketplace. For example, during wintertime the demand for natural gas usually exceeds supply as consumers use more gas (and electricity converted from gas) to heat their homes and premises. It therefore becomes necessary to withdraw natural gas from storage during cold periods (peak demand) and inject it into storage during spring, summer and fall months. Indeed, storage inventory has a very strong seasonal cycle (see graph below), which is key to understanding the very nature of the gas market in general.

Price

In the United States, natural gas futures trade on the New York Mercantile Exchange (NYMEX); they were launched in April 1990. Physical delivery is to a place called Henry Hub in Louisiana. The futures trade in US dollars per million BTUs ($/mmBtu).

Just like for any other commodity on this planet, the balance between supply and demand determines the price. As can be seen from the graph below, natural gas price volatility has been very exciting in the 21st century.

In the next part of our natural gas series, we will take a closer look at the demand side of the market.

This article is part of the Forex Magnates Community project . If you wish to become a guest contributor, please apply here: UGC Form .

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What is natural gas?

Natural gas is a fossil energy source that formed deep beneath the earth’s surface. Natural gas contains many different compounds. The largest component of natural gas is methane, a compound with one carbon atom and four hydrogen atoms (CH4). Natural gas also contains smaller amounts of natural gas liquids (NGL, which are also hydrocarbon gas liquids), and nonhydrocarbon gases, such as carbon dioxide and water vapor. We use natural gas as a fuel and to make materials and chemicals.

How did natural gas form?

Millions to hundreds of millions of years ago and over long periods of time, the remains of plants and animals (such as diatoms) built up in thick layers on the earth’s surface and ocean floors, sometimes mixed with sand, silt, and calcium carbonate. Over time, these layers were buried under sand, silt, and rock. Pressure and heat changed some of this carbon and hydrogen-rich material into coal, some into oil (petroleum), and some into natural gas.

Where is natural gas found?

In some places, natural gas moved into large cracks and spaces between layers of overlying rock. The natural gas found in these types of formations is sometimes called conventional natural gas. In other places, natural gas occurs in the tiny pores (spaces) within some formations of shale, sandstone, and other types of sedimentary rock. This natural gas is referred to as shale gas or tight gas, and it is sometimes called unconventional natural gas. Natural gas also occurs with deposits of crude oil, and this natural gas is called associated natural gas. Natural gas deposits are found on land, and some are offshore and deep under the ocean floor. A type of natural gas found in coal deposits is called coalbed methane.

Source: Adapted from United States Geological Survey factsheet 0113-01 (public domain)

Operators preparing a hole for the explosive charges used in seismic exploration

Source: Stock photography (copyrighted)

How do we find natural gas?

The search for natural gas begins with geologists who study the structure and processes of the earth. They locate the types of geologic formations that are likely to contain natural gas deposits.

Geologists often use seismic surveys on land and in the ocean to find the right places to drill natural gas and oil wells. Seismic surveys create and measure seismic waves in the earth to get information on the geology of rock formations. Seismic surveys on land may use a thumper truck, which has a vibrating pad that pounds the ground to create seismic waves in the underlying rock. Sometimes small amounts of explosives are used. Seismic surveys conducted in the ocean use blasts of sound that create sonic waves to explore the geology beneath the ocean floor.

If the results of seismic surveys indicate that a site has potential for producing natural gas, an exploratory well is drilled and tested. The results of the test provide information on the quality and quantity of natural gas available in the resource.

Drilling natural gas wells and producing natural gas

If the results from a test well show that a geologic formation has enough natural gas to produce and make a profit, one or more production (or development) wells are drilled. Natural gas wells can be drilled vertically and horizontally into natural gas-bearing formations. In conventional natural gas deposits, the natural gas generally flows easily up through wells to the surface.

In the United States and in a few other countries, natural gas is produced from shale and other types of sedimentary rock formations by forcing water, chemicals, and sand down a well under high pressure. This process, called hydraulic fracturing or fracking, and sometimes referred to as unconventional production, breaks up the formation, releases the natural gas from the rock, and allows the natural gas to flow to and up wells to the surface. At the top of the well on the surface, natural gas is put into gathering pipelines and sent to natural gas processing plants.

Because natural gas is colorless, odorless, and tasteless, natural gas companies add mercaptan to natural gas to give it a distinct and unpleasant odor to help detect leaks in natural gas pipelines. Mercaptan is a harmless chemical that smells like rotten eggs.

Natural gas is processed for sale and consumption

Natural gas withdrawn from natural gas or crude oil wells is called wet natural gas because, along with methane, it usually contains NGL—ethane, propane, butanes, and pentanes—and water vapor. Wellhead natural gas may also contain nonhydrocarbons such as sulfur, helium, nitrogen, hydrogen sulfide, and carbon dioxide, most of which must be removed from natural gas before it is sold to consumers.

From the wellhead, natural gas is sent to processing plants where water vapor and nonhydrocarbon compounds are removed and NGL are separated from the wet gas and sold separately. Some ethane is often left in the processed natural gas. The separated NGL are called natural gas plant liquids (NGPL), and the processed natural gas is called dry, consumer-grade, or pipeline quality natural gas. Some wellhead natural gas is sufficiently dry and satisfies pipeline transportation standards without processing. Chemicals called odorants are added to natural gas so that leaks in natural gas pipelines can be detected. Dry natural gas is sent through pipelines to underground storage fields or to distribution companies and then to consumers.

In places where natural gas pipelines are not available to take away associated natural gas produced from oil wells, the natural gas may be reinjected into the oil-bearing formation, or it may be vented or burned (flared). Reinjecting unmarketable natural gas can help to maintain pressure in oil wells to improve oil production.

Coalbed methane can be extracted from coal deposits before or during coal mining, and it can be added to natural gas pipelines without any special treatment.

Most of the natural gas consumed in the United States is produced in the United States. Some natural gas is imported from Canada and Mexico in pipelines. A small amount of natural gas is also imported as liquefied natural gas.