Midsummer 2008 witnessed a precipitous decline in the price of natural gas that had many wondering if prices ever moved anywhere other than down. But the pace and scope of the sell-off has had the same effect on the market as a natural forest fire can have on the long-term health of the forest. It brought prices back into equilibrium.
Natural gas was one of the stars in a variety of bull markets that took commodities prices to all-time highs this spring. With oil prices at all-time records, a shortage of gas in storage and liquid natural gas being pitched as the fuel of the future, the futures contract became a speculator and fund favorite. The hoopla that generally surrounds the “official” start to hurricane season often brings in additional spec buying, which added an extra layer of froth to this market. But specs are a fickle crowd and as a mild summer played out and natural gas stocks started to build, the longs began to liquidate. And liquidate they did, with gas prices tumbling nearly 30% within a three-week period during July. The selling continued into August.
The correction was justified. However, as markets often do, natural gas prices may have overcompensated a bit and now could be at a longer-term value level for put sellers. In fact, fundamental fair value for natural gas is probably at or above current price levels. A series of outside events is most likely artificially extending the downside momentum in gas. Mild U.S. summer temperatures, government investigations into hedge fund energy trading and a general liquidation trend in commodities over the last several months have all added to natural gas’ price woes.
But if one peels off the superficial factors, natural gas has a number of fundamentals working in its favor that put sellers should begin considering now.
At the time of this writing, natural gas supply figures show that with 2.461 billion cubic feet in storage, supplies remain below the five-year average and 12.7% below year ago stock levels. Hurricane season often provides the most tropical activity during September and October, which should make shorts hesitant to aggressively sell gas over the next several weeks. A hurricane of any magnitude in or around the Gulf of Mexico would be bullish for prices. A less spectacular but more likely reason for gas prices to rally is that August/September typically marks the seasonal time period when distributors begin accumulating inventory. This is done to have enough supply on hand to meet winter demand needs. This usually creates higher demand at the wholesale level and is often supportive to prices.
While natural gas now could be near a fair value, one can never fully rule out a retest of the lows or even new lows after such a precipitous decline. This is why we recommend selling puts.
Remember, as a seller of puts, one only needs the market price to remain anywhere above his strike to eventually be profitable. Thus, prices do not necessarily need to move higher for a successful trade.
We like selling the December puts at strikes below the $6.80 level as a solid value play in natural gas. If at option expiration in November, natural gas prices are anywhere above the strike price, the option expires worthless and the seller keeps all premium collected as profit. As of the first week of August, the December 680 natural gas put was valued around $750 and the approximate net margin for the position was $2,300. While the premium and margin for the put will vary with the market, there likely would be little time decay from that price by Sept. 1. The benefit? The seller of the put does not have to pick the absolute bottom in natural gas prices. He is only picking a level far beneath the market that he feels it cannot attain. Given the fundamentals that face the market in the upcoming month, we feel it is a fairly sound investment.
James Cordier and Michael Gross are portfolio managers with Liberty Trading Group/OptionSellers.com. They are authors of the book “The Complete Guide to Option Selling” (McGraw-Hill 2005) and can be reached through their website www.OptionSellers.com .
