Natural gas is one of the fossil fuel trinity that despite the transition towards zero-carbon, renewable energy, remains an essential part of global energy mix.

It is composed largely of methane (CH4), a colourless hydrocarbon that is highly flammable, making it suitable for heating homes and businesses along with generating electricity.

It has powered large sections of economies for more than 150 years and its importance has been aptly demonstrated by how high prices have risen in Europe due to a combination of dwindling stockpiles and concerns about ongoing supply due impact from the Russian invasion of Ukraine and the resulting sanctions levied on Russia.

So just what are the key factors that determine how natural gas is priced?

Inflation drives prices

The first factor – inflation – actually impacts on the prices of everything fom consumer goods and financial assets to the price producers pay for raw materials and machinery.

And natural gas (along with its stable mate oil) is one of the first commodities to be affected by inflation due to the high capital costs associated with its production and transportation.

To make it worse, energy costs trickle through to other expenses, meaning that it plays an outsized role in driving up the rate of inflation.

Oh and did we mention that natural gas is a key component in the production of ammonia and fertilisers? Well it is and higher gas prices also mean an increase in the cost of food production though this takes longer to flow through value chains.

Weather fans gas movements

Weather also plays a role in how gas is priced. Simply put, a colder than usual winter creates greater demand from residential and commercial consumers, leading to higher prices.

This typically means that the prices in the northern hemisphere tend to spike in the three months prior to December though hot weather can also result in the increased use of air conditioning, which increases natural gas demand.

Extreme weather can also affect prices by shutting in infrastructure.

The pressure cooker of Geopolitics

Geopolitical tension and conflict can also impact on natural gas prices as highlighted by recent events.

Capital.com chief market strategist David Jones noted that while geopolitical tension over eastern Ukraine had been building for weeks, markets still seemed surprised by the Russian invasion judging by the reaction of traders.

“On the first day of the invasion, markets reacted swiftly, particularly the main European
benchmark which was up more than 40%,” he added.

“Traders possibly reacted in this way because of the threat to supply caused by hostilities,
and also any potential wider sanctions against Russia by the West.”

This is thanks to Europe importing anywhere from a third to 40% of its gas from Russia.

As a hedge against the possibility of Russia cutting supplies off entirely – it has already reduced by a quarter, Europe has been importing larger quantities of liquefied natural gas that has been supercooled into a liquid for transportation over long distances.

Green transition

The last factor could actually lead to a reduction in natural gas prices over the long term and that is the ongoing transition towards the use of more sustainable energy.

Increasingly, both companies and countries have made efforts to reach net zero emissions by 2050 through greater investment in renewables.

This is especially true as the increasing intensity of natural gas as an official European Commission “transitional energy source” is temporary at best.

“If you look at some of the historical moves in natural gas over the years, it does look like sentiment can change very quickly compared to other major markets,” Jones added.

This makes natural gas a frustrating commodity to trade in but offers investors the opportunity for high risk or reward outcomes that come with such volatile markets.

Read MoreNatural Gas

You might be interested in