It is only April and already the hurricane gang is talking up another “big year” for the Southeastern United States. Meanwhile, a second group has emerged to challenge the notion of an active season, citing the same wind shear factors this year that rendered the 2006 season a pleasant dud. And what about global warming? Does it create more or less hurricane activity? The experts are split.
Regardless, betting for or against a hurricane is for Vegas; for serious investors, however, gambling is not part of the program.
Nevertheless, hurricane fever is in the news and the investing public is busy seeking opportunities to take advantage of an active season. And what better way to play a hurricane than buying natural gas? After all, in a market where the United States meets virtually all of its annual demand through domestic production, a full 25% of that production comes from Gulf of Mexico rigs. Anyone doubting the potential for natural gas prices to rally in the wake of a major, rig-damaging hurricane need only look at a price chart of natural gas for October of 2005 in the aftermath of Hurricane Katrina.
The public, of course, is getting busy buying calls. Always a favorite of the small spec, call buying allows the trader to be long the market with a built in downside risk. The drawback, of course, is that many investors will buy calls so outrageously out of the money the chances of them ever going in the money are remote, even if a rare rig-damaging storm does come along this year. Torpedoes be damned, the small spec pushes on, encouraged, no doubt, by an army of eager brokers touting this year’s hurricane predictions.
As is generally our philosophy, there is profit to be made in fading the public.
Are we recommending selling calls to hold through hurricane season? No, we are not. Profitable as that would have been in 2006, the risk does not justify the potential profit in our opinion. There are however large amounts of speculative capital pouring into natural gas calls in these months leading up to hurricane season, and this is where we feel the profit opportunity lies.
For while the public is currently bidding up values of natural gas call options, there will be substantial time deterioration between now and the time the possibility of an actual hurricane arrives. In addition, the call buyers seem to be buying on the outside chance of a hurricane while ignoring the actual fundamentals and seasonal tendencies of the natural gas market, which currently appear decidedly bearish. Therefore, option sellers willing to collect premium from spec buyers now should be able to benefit not only from time deterioration, but option decay resulting from steady-to-lower natural gas prices materializing prior to the season’s first storm threat.
We base this fundamentally bearish outlook on a number of factors including those highlighted below:
April and May are typically known as injection season, also known as shoulder months, for natural gas when distributors accumulate inventory to meet summer cooling needs. Natural gas is used to fire electricity generators used to meet the increased load demand brought on by air conditioning use. Bulls argue that this should add support to natural gas prices in the near term. We disagree. Despite this April’s cold snap, the United States had an unusually mild winter, allowing natural gas supplies to accumulate to burdensome levels. At the time of this writing, gas supplies in storage total 1.546 trillion cubic feet (tcf), a hefty 22.1% above the five-year average for this time of year. This left over winter natural gas means distributors not only have to buy less gas this year, but they will be more finicky about buying at a value price. We do attribute the rally in gas prices over the last 30 days, at least in part, to seasonal industry buying. However, we expect commercial buying strength to be largely muted in the weeks to come as the market grapples with excess supply.
Shoulder months are also the time of year when natural gas demand at the retail level is at its lowest. With winter over and summer heat not yet present, the risk of a weather related price spike is virtually eliminated during this period.
Past performance is not indicative of future results. With that said, natural gas prices have a strong seasonal tendency to drop sharply during June and into July. Typically by late May, distributors have often reached a point where summer storage levels are considered adequate and commercial purchases begin to slow. Meanwhile, summer retail demand has not yet fully materialized. With supplies high and with commercial and retail demand slow, prices of the commodity tend to decline.
The speculator interest in purchasing call options has created an opportunity for call writers to collect inflated premiums on what appear to be heavily overvalued options. There is currently solid premium available at strike prices that are literally double the current cash price of natural gas and at levels well above 2005’s post Katrina highs.
We advise writing these options and taking advantage of the time decay that will occur over the next two-and-a-half months. Hurricane season for the United States technically begins on June 1. However, most hurricane activity in the Gulf of Mexico will typically occur in August and September. During June and July, Gulf waters are generally not yet warm enough to feed a tropical storm, especially not a strong one. Nonetheless, conservative option sellers will want to close positions and take any profits off the table by early July. While storm related supply disruptions are rare for the natural gas market, hanging on for a few extra dollars does not justify the increased exposure.
The early bird may get the worm. However, for early bird storm chasers, the worm comes at a hefty price – one that option sellers could conceivably convert to profits.
For more details on our long term outlook for energy prices, be sure to watch James Cordier’s on air interview with Bloomberg Television, April 4, 2007, now available at www.libertytradinggroup.com/news.html.
James Cordier and Michael Gross
Liberty Trading Group
401 East Jackson Street
Suite 2340
Tampa, FL 33602
(800) 346-1949
www.optionsellers.com
We will be working closely with client portfolios to identify call selling opportunities in natural gas over the next seven to 10 days. If you would like more information about selling options in the energy markets or building a portfolio based on the option selling approach, please feel free call or visit us on the web at www.optionsellers.com.
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 featured by international financial publications and worldwide news services including The Wall Street Journal, Yahoo Finance, CNBC 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.
