Cold weather this week has natural gas prices on a tear after trading at the lowest prices in nearly four years only a few weeks ago. However, instead of jumping on the bull bandwagon and buying into a weather rally, the prudent play may be to sell call premium far above the current price of this supply-burdened market.
Despite what you may think about a couple of gunslinger traders at Amaranth, the Natural gas market is typically a very cyclical market that can offer some extremely high probability trading for investors familiar with its characteristics.
Natural gas is used primarily as a fuel to either produce heat directly in a home or to power facilities that produce electricity to heat or cool homes. This means that natural gas will have supply and demand cycles that ebb and flow with the seasons (at least in North America).
In the United States, we are currently nearing the end of what is known as injection season. Injection season is when distributors stockpile or inject large quantities of gas into storage to insure enough supply to meet winter heating needs. Injection season typically begins in August and ends in late October or early November.
November then begins the winter heating season, also known as the draw season in the trade. This is because end-user demand begins to pick up and instead of weekly injections into storage, retail demand begins to draw inventory out of storage. Therefore, instead of building, inventories now begin to fall.
It is not rocket science.
Traders will often talk of buying natural gas ahead of the winter heating season. However, in most years, this would have been a mistake. Why? Because the NYMEX contracts track the wholesale price of natural gas, not the retail price. Wholesale demand will obviously be the highest during injection season, as distributors buy from producers and sock gas away into storage. Thus, it is not uncommon to see natural gas prices rise during injection season and then peak right as winter heating season begins in November.
Therefore, traders who bought natural gas in October or November in anticipation of winter heating demand would have, in most years, already have missed the move. Moore Research Center produces some excellent graphs of this seasonal tendency. If you are already a client of Liberty Trading Group, you can receive a copy of this chart upon request.
This year, however, has produced a slightly different fundamental picture, which has altered normal seasonal tendencies. Instead of rallying through injection season, prices have actually declined dramatically. Before considering seasonal tendencies for the remainder of 2006, we must first be sure we understand why this decidedly counter-seasonal move took place this year.
It is our opinion that this price move can be summed up in one word: Hurricanes; or more precisely the lack of hurricanes.
With the major hurricanes of 2004 and last year’s Katrina disaster still fresh in investors minds, natural gas traders were geared up to buy ahead of the 2006 storm season. It seemed like a logical trade. In 2004, we set a record for major hurricanes in the Atlantic and Caribbean region. In 2005, we saw more than 70% of Gulf of Mexico natural gas production knocked off line when Katrina roared through key drilling areas. Analysts were predicting another active year in the Atlantic. This year, the bulls were ready to make a killing.
As we now know, it never happened. The 2006 hurricane season was a flop. Yet, during the months of June and July, speculative investors piled into natural gas as a long play. But as the weeks and then months passed without storms and with some help from a relatively mild North American summer, supplies were able to build at a pace far above normal. By August, with supplies substantially above last year and well above 12-year averages, speculators began to liquidate long positions. This turned into a massive liquidation by small specs and funds and explains why natural gas prices were able to fall despite distributors accumulating inventory.
Fear (or expectation) of a repeat of 2004 and 2005 skewed the seasonal.
Meanwhile, an eventless year in the Gulf combined with a cool summer have allowed distributors to build the largest pre-winter natural gas stocks in history. As of this week, U.S. natural gas stocks stood at 3.442-trillion cubic feet. This is 501-billion cubic feet, or 14.5%, more than the 12-year average and an all time record for this time of year. Many analysts expect this figure to eclipse a staggering 3.5 trillion cubic feet before the injection season ends.
This oversupply allowed prices to continue the decline that began in August until Natural Gas reached the lowest price levels seen in almost four years. This price level was attained earlier this month.
Lately, however, we have seen a rally in natural gas prices that has some traders ready to wave the bull flag again. Is it time to buy natural gas?
We don’t think so. Natural gas prices have been responding to a group of very short-term fundamentals that should not last much longer. They include:
The first real brush of cold weather in the Northeast and Midwestern US occurred this week and could continue into next. This is usually good for a bump in gas prices as specs buy the weather.
We are at the time of year when nuclear power plants go offline in order to refuel. Nuclear plants tend to refuel in fall and spring when power demands are lower. When nuclear power plants are down, demand for natural gas fueled replacement power ramps up. This is again, however, a short term fundamental. Most nuclear power plants should be back online by mid-November.
We are probably also seeing an end of injection-season push by distributors to top off supply before winter. As the spec selling has eased, this is probably allowing prices to climb a bit as well – playing a little catch up with the normal seasonal tendency.
While the market could still have some short term upside because of these factors, we don’t believe it has the legs to sustain a longer-term price move to the upside with the massive supply hanging over the market. True, cold spells can move the market for a few days at a time during the winter months; sometimes longer. However, even an unusually cold winter would not seem to be enough of a catalyst for a sustained move given current supply and price levels.
Our outlook is not necessarily for prices move lower. They very well may. However, our point is only that prices are going to have a hard time moving substantially higher. It is our opinion that the current situation in natural gas is ideal for our strategy: option selling; more specifically, call selling. The short-term weather strength has prices moving higher. This is driving call premium higher as specs drive up prices of far out of the money calls. There are now winter natural gas calls available at strikes more than double the current price of natural gas. Strikes are available at levels $2-$3 higher than last years post Katrina, all-time highs.
Remember that when selling calls, all the market has to do is stay below your strike price through expiration for you to profit. Thus, a trader who sells a $17.00 call option would only have to have prices remain anywhere below $17.00 per Btu to profit. To put this in perspective, last year’s post Katrina high was about $15.00 per Btu. This was established with 70% of Gulf production offline.
With supplies now at all time highs, we see the chances of prices climbing to levels anywhere near last years highs as remote at best, regardless of weather. There are currently options available well above these levels offering premium in the $500-$600 per option range, which we feel is a bargain.
Of course, we recommend these as part of an overall diversified option portfolio. We will be working closely with our clients in establishing positions on additional strength in the market over the next seven to 14 days.
If you would like more information about selling options in the natural gas market or building a portfolio based on the option selling approach, please feel free to call or visit us on the web at www.optionsellers.com.
Liberty Trading Group
401 East Jackson Street
Suite 2340
Tampa, FL 33602
(800) 346-1949
www.optionsellers.com
You can now watch James Cordier’s “Best in Class” appearance On Bloomberg Television, Oct. 4, 2006 where James is interviewed on the energy markets at http://www.libertytradinggroup.com/news.html
James Cordier is head trader and president of Liberty Trading Group, a futures brokerage firm specializing in option writing on commodities. James’ market comments are published by several international financial publications and worldwide news services including The Wall Street Journal, Reuters World News and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
