One of the more enticing factors of investing in commodities is the seasonal nature of supply/demand cycles in certain markets. In some agricultural markets, planting and harvest cycles can play a considerable role in price direction as fear runs highest during growing seasons, while supply runs highest during harvest. In “The Complete Guide to Option Selling,” we make many references to the powerful strategy of selling put or call options in favor of seasonal tendencies.
It is true that past performance is not indicative of future results. Just because prices have moved a certain direction in year’s past does not mean they will move similarly this year. However, if one can determine the fundamental factors that have moved prices in years past and determine if those factors are similar this year, one can utilize that data in making price projections for the current year.
The energy markets, in contrast to agricultural commodities, experience seasonal tendencies based more on demand cycles rather than supply cycles. And nowhere is this demand cycle more pronounced than in unleaded gasoline.
If you live in the Northern Hemisphere, you may have noticed that you often pay more for unleaded gas during the summer months. This is not due to coincidence nor is it due to any magical formula set forth by oil companies. It is basic supply/demand economics. The Northern Hemisphere summer brings, what has come to be known as “driving season” in the United States and Europe. With warmer weather and kids out of school, the public is more apt to travel. This typically creates a surge in gasoline consumption at the retail level, which in turn, has tended to drive up prices at the pump beginning in May and peaking in July or August.
A key aspect of seasonal analysis is that price tends to precede consumption. Thus, while prices at the pump will tend to rise during the summer months, demand at the wholesale level tends to begin rising in early March as distributors begin to build gasoline inventories in order to have enough supply on hand to meet summer demand. Thus, in the past, prices on the wholesale level (read: futures contracts) have tended to rise in accordance with this increase in commercial demand.
Of course, other factors influence the price of gasoline as well. However, during this time of year, they are set against the backdrop of this rising demand. In our opinion, seasonal demand alone should be enough to underpin gasoline prices to the point where put selling becomes an attractive strategy for high probability income on a portfolio. However, an overall view of the current fundamentals affecting gasoline prices has convinced us that there are several factors in addition to rising demand that should contribute to higher prices this spring. For those readers in the Southern Hemisphere, we use the term “spring” and “summer” in accordance to the United States and Europe, as we see demand in these regions as the key factor driving prices at the New York Mercantile Exchange.
Before establishing a bullish position in the market, an investor should first understand the fundamentals that drive gasoline prices to determine if they support a favorable market move or non-move.
There are three factors that will determine the ultimate price of unleaded gasoline (or reformulated gasoline blendstock for oxygenate blending RBOB, as it is now known at the exchange.)
The price of crude oil. As the primary ingredient in unleaded gas, crude prices can obviously have a major impact on gasoline prices, although this relationship can work in reverse as well. Factors that affect crude prices such as industrial usage, supply disruptions or geopolitical events can have a big affect on unleaded gas prices. At present, U.S. crude stocks remain at an annual deficit and are, surprisingly, 17.4 million barrels below year-ago levels. We see the risk of a sizable move in crude prices more to the upside than the downside as we remain moderately bullish the crude market (see “Dip in crude prices should be opportunity for put sellers,” 1/5/07 – www.optionsellers.com.)
Gasoline demand. As discussed above, wholesale gasoline demand tends to begin rising in March. However, the longer-term demand picture for gasoline appears bullish as well. Despite all the talk of ethanol and a slowing economy, gasoline demand remains well above the five-year average and even above the consumption levels of 2006, when gasoline demand set a record. The EIA estimates that overall U.S. gasoline consumption will increase by 1.2% in 2007 and another 1.2% in 2008. Current gasoline consumption is running about 9.2 million barrels per day. Yet, over the last 15 years, gasoline consumption has surged by an average of nearly 9% between early March and peak demand season in late July. An equivalent surge in demand this year would put daily U.S. consumption at nearly 10.03 million barrels per day, an all time high.
Gasoline Supply. U.S. Gasoline stocks were running at an annual surplus as of February – as much as 5% above the five-year average. But a consistently strong demand for fuel through the U.S. winter has helped whittle inventories down to about even with the average for this time of year. This week’s EIA report saw stockpiles fall by 3.8 million barrels to 216.4 million barrels. This was more than twice the drawdown that analyst had expected. However, stronger than normal winter demand is not the whole story. Shipping delays and lower imports from Europe have been cited as reasons for the supply drawdowns. Nonetheless, the United States acquires most of it’s gasoline from domestic production. And U.S. refinery facilities are antiquated at best. Each year, refinery maintenance seems to take longer and run into more glitches, resulting in more production going offline. This week, the refinery-operating rate fell to 85.8%, well below the already unspectacular 87.3% five-year average. This has prevented refiners from ramping up unleaded production and has brought concern to the market that inventories will be inadequate to meet summer demand.
The EIA projects gasoline prices at the pump will average $2.60 per gallon during the April to September period. This would be 32¢ per gallon higher than the February 2007 average price and would equate to roughly $2.10 to $2.20 on the wholesale level.
While we believe the chances of gasoline trading at the levels mentioned above are good as we approach the U.S. summer, we feel the chances of prices not falling substantially are even better. This is why we believe that put selling is an excellent income strategy to employ over the next 60 to 90 days in the unleaded gas market. Remember that when selling puts, the market does not necessarily have to move higher for the seller to profit. It only has to remain above the seller's strike price. It is our opinion that there are some high-probability strike-price levels now available in this market, far below today’s futures price.
As we said to Bloomberg News this week, we feel crude and unleaded probably are a bit overbought and due for a pullback in the short term. However, we would view this as a correction in a bull market and an opportunity to sell puts far below the current market. We will be working closely with clients over the next 7 to 10 days in determining put selling strategies appropriate for different risk tolerances in this market.
James Cordier and Michael Gross
Liberty Trading Group
401 East Jackson Street
Suite 2340
Tampa, FL 33602
(800) 346-1949
www.optionsellers.com
If you would like more information about selling options in Unleaded Gasoline 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 .
Be sure to catch Liberty Trading’s James Cordier Live on CNBC, this Monday, March 12 at 10:15 am EST. James will be discussing price projections for energies and other commodities.
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. Cordier and 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.
