In our spring review of energy markets, we highlighted the case for a bullish position towards the unleaded gas market. Since that time, unleaded prices at the New York Mercantile Exchange (Nymex) have increased by more than 15%. While sellers of unleaded puts have undoubtedly done well, the media’s unrelenting focus on gasoline prices, along with some key fundamental changes in the market, have convinced us that there is now ample reason for investors to begin considering bearish positions on gasoline and its cousin, heating oil.
For our portfolios and readers of this column, that means selling calls – at strikes far above current price levels.
Investors who follow the nightly news may question the wisdom of selling calls in the energy markets at this time. After all, according to the national media, it is summer time and the United States does not have enough gas. But the inventory and refinery numbers are starting to tell a different story.
Gasoline prices climbed to their present level primarily due to two factors: seasonal wholesale buying and low refinery operating rates. While peak demand for gasoline at the retail level occurs during the summer driving months, wholesale demand is often strongest in the month’s preceding the U.S. summer as distributors accumulate inventory in order to meet summer retail demand. Thus, the axiom price precedes consumption. As prices at the Nymex reflect wholesale values, there is a seasonal tendency for Nymex gasoline prices to rise during the U.S. spring and then gradually decline into the summer months. Thus, ironically, it is often the case that as prices are rising at the pump, Nymex prices can actually be declining. As we are now officially into the U.S. summer, distributors are reaching, or could have already reached, the point where they have accumulated adequate supplies to meet summer demand. When this point is attained, buying at the wholesale level tends to wane.
Refinery operating rates remain well below the five-year average of 94.31%. But this weeks EIA data shows refinery rates jumping 1.83% over last week’s 87.6% figure. And with operating rates increasing, there is no shortage of crude oil to be refined. The EIA pegged U.S. crude stocks at 350.9 million barrels, an increase of 1.562 million barrels over last week. U.S. crude stocks are now at an eight-year high and stand 28.4 million barrels above the 15-year average for this time of year. While media attention, fund buying and continued growth of international demand have driven crude prices back to $70 a barrel, there is no shortage of oil in the United States at this time.
EIA gasoline stocks fell by 700,000 barrels, which some analyst deemed bullish since many were expecting a build in stocks this week. But the net change in gas stocks over the last four weeks has been a rise of 4.6 million barrels, showing that the longer-term trend is towards rising gasoline stocks and in line with seasonal norms.
The fact that many analysts deemed the report bullish is puzzling. Gasoline stocks were called bullish because of a one-week drawdown in stocks. The report was called bullish for crude because of the rising refinery-operating rate, which should begin to use up some of the excess crude stocks.
Increased refinery runs will begin to use up excess crude and covert it into gasoline. We believe we are finally reaching a point where refineries are beginning to catch up on gasoline production, which should begin to weigh on Nymex gas prices in the coming weeks.
At the same time that production is increasing, we see a seasonal pattern emerging on the demand side as commercial buying begins to fade. Thus, we believe unleaded gasoline could be near seasonal highs, presenting an opportunity for call sellers.
As the media has done their usual job of whipping the public into a frenzy over summer gas prices, there are call options available with solid premiums at strikes more than 50% above today’s current futures price. We believe taking premiums on these calls for late 2007 contracts makes good sense for investors. From a risk standpoint, the strikes currently available are far enough above the market to allow investors to remain comfortable even if seasonal highs are not yet in place.
Investors seeking distant call premiums may also consider selling heating oil calls. Although stocks are currently standing at 7.6 million barrels below last year’s levels, increased refinery operation will also result in heating oil stocks beginning to build. As we are four to six weeks away from normal seasonal accumulation period, when distributors begin accumulating inventory to meet U.S. winter heating needs, heating oil appears to be an overbought market entering a slack demand period.
Liberty Trading Group
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 a research 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