Contributor: Dr. Vince Kaminski, Rice University
Over the last few days this month, the February natural gas contract fell from $3.06/MMbtu to $2.32, down almost 25%, and then recovered to $2.554/MMBTU on Tuesday (1/24). Obviously the market decline was a response to continuing oversupply and extremely mild winter temperatures. But there was another factor at work which has important implications for the future behavior of natural gas prices.
The market’s access to fundamental information has become much more homogeneous. Only a few years ago, the sources of data available to trading shops varied widely, as did the analytical ability to interpret that data. Consequently, there was a reasonably wide diversity of opinion as to the direction, magnitude and duration of any particular market move. But today that has changed. Fundamental data from analytics companies are now widely available. Market analysis has become more standardized as analysts move from one trading shop to another, and a cottage industry of consulting firms, conference producers and trading advisors supports propagation of most advanced techniques across the industry.
Internet and social networks facilitate sharing information better than any watering hole in Houston or Lower Manhattan. Sources for fundamentals data are readily available to companies large and small. Call it ‘information transparency.’
One of the unexpected consequences of more democratic access to information is the proliferation of similar trading strategies, based on the same fundamental data and the same conceptual framework. As Didier Sornette put it, “a central property of a complex system is the possible occurrence of coherent large-scale collective behaviors with a very rich structure, resulting from the repeated nonlinear interactions among its constituents: the whole turns out to be much more than the sum of its parts.”[1] The strategies of the best, often legendary traders, become what is called sometimes “secret of Polichinelle,” or a common knowledge. It is widely recognized that “me too” strategies, based on replicating the trades of Long Term Capital Management, became so pervasive that they contributed to its downfall. Trading positions decided by an individual trader, in isolation from the rest of the market, but based on the same notions and information, may be perfectly sound, but in combination add up to an explosive mix. All the loose cannons roll to the same side of the ship. [2]
When this happens simultaneously, even a minor shock, a proverbial butterfly flapping its wings, may move the market a lot. With many similar trades hitting the market at the same time, market moves can become exaggerated. And the exaggerated moves have the potential to self-perpetuate as technical traders jump on the band wagon. Stop loss orders are triggered, options positions are re-hedged, risk managers force the traders out of their positions (we can debate in a different post when it makes sense and when it does not) and major price moves, often artificially amplified and exceeding the levels justified by fundamentals, occur.
The move over the last two weeks was only a preview of the spikes and crashes that may be ahead as natural gas navigates a new supply-demand balance reality. For traders of volatility, this phenomenon will present interesting opportunities. It may not be so favorable to producers and end users looking for stable, predictable markets. It also teaches one important lesson to the traders. Understanding the positions of other players is as important as studying the weather and supply/demand trends. One consolation I can offer to anybody who lost money over the last few days comes from Keynes: “Worldly wisdom teaches that it is better for reputation to fail conventionally then to succeed unconventionally.”
--------------------------------------------------------------------------------
[1] D. Sornette, “Critical market crashes,” Physics Reports, 378 (2003) 1–98, www.elsevier.com/locate/physrep
[2] One can point out, quite correctly, that the longs and shorts have to be balanced as there is a buyer for each seller. The problem is that sometime we may have, for example, one type of market participants, who are highly leveraged and ready to turn on a dime, selling en masse to commercials, “trade and forget” buyers, more than happy to accommodate prices they perceive as unsustainably low.
