From the December 01, 2009 issue of Futures Magazine • Subscribe!

How supply/demand affects gasoline prices

With all of the macro-economic noise in the markets right now, it may seem counterintuitive to focus on something as “old school” as seasonal tendencies. Yet despite GDP reports, Buffet buyouts and Chinese manufacturing, the annual everyday supply/demand cycles of physical commodities can hold a stronger influence on price direction than any other factor.

While agricultural commodities are often affected by planting and harvest cycles, there is no market more influenced by demand cycles than the energy markets. For example, unleaded gasoline demand spikes during the U.S. summer months when weather is mild, kids are out of school and travel is favorable. But what happens after driving season?

There is a sharp drop in retail gasoline demand in September. This drop in demand often causes a price slide in the wholesale gasoline market. At the same time, refineries begin switching over to heating oil production to build inventory for winter. Therefore, gasoline production takes a back seat and wholesalers allow inventories to be sold off, drawing down stocks.

It is not uncommon during autumn to see gasoline prices declining even though stocks often are declining at the same time. The drop in demand tends to trump all.

However, in 2009, while demand dropped off as usual, inventories have not yet experienced the normal seasonal drawdown. Inventories remain more than 5% above seasonal norms and 7% higher than 2008 levels. This drop in demand while supplies remain high normally would lead to a more pronounced decline in prices. It has not. Why is that?

There are occasionally times when markets temporarily disconnect from pricing existing fundamentals and go off in their own direction. Like a teenager in love, they can stray wildly, allowing emotion, not reason to temporarily lead them.

Energy markets are currently being supported by a stimulus created euphoria. At the very least, they are being supported by an expectation of global economic recovery. In short, the market is pricing in demand that is simply not there yet.

These expectations, spurred on by a weaker dollar and higher equities market, have resulted in speculative money pouring into the energy markets. The Oct. 27 Commitment of Traders report with options showed spec and fund net long positions hit an all-time record high of 181,672 contracts. Unleaded (RBOB) gasoline longs are within 5% of the all-time highs attained in May of 2008. This means momentum following fund managers and John Q. Public are betting on higher prices. Commercial traders, of course, are heavily short and adding to short positions across the petroleum sector.

Technical traders refer to this kind of set up as “overbought.” Our view of the energy markets is one of overstocked inventories, seasonally weak demand and a technically overextended market ripe with speculators. It’s a set up for a stout correction. But like the teenager, nobody knows when he’s coming home.

Energy prices are no different. Crude, heating oil and unleaded gas rallies have run into some recent headwinds. This could be the beginning of a fundamentally based retracement.

A trader can get short with a relatively tight stop above what appears to be a triple top (see “Major resistance”). Then again, speculative led strength cannot be discounted in the short term and may lead to another shorting strategy.

The spec interest in the energy markets comprises a large percentage of individual traders whose preference is to buy options, specifically calls. This demand for calls inflates premiums, even at strikes that are highly unlikely to ever be attained. While this is true across the energy sector, unleaded gasoline has the added advantage of seasonal price pressure. For instance, calls are currently available in unleaded gasoline that are more than 100% out of the money. You can collect premium on strikes more than double the current value of unleaded gasoline on the Nymex.

This scenario highlights the benefits of an options writing strategy. As long as unleaded gasoline prices do not double prior to expiration, the option will expire worthless and the seller keeps the premiums. Only an explosive move to the upside can force the deep out of the money call seller’s hand.

Energy prices may still have some spec momentum to the upside. However, the fundamental weight now pressing on the market should keep things from going too far. Selling deep out of the money calls could be the most consistent method of capitalizing on an expected correction, even if it never comes.

James Cordier is head portfolio manager of Liberty Trading Group, an investment firm specializing in selling options. His market comments are featured by the Wall Street Journal, Forbes and CNBC. He is author of “The Complete Guide to Option Selling” (McGraw Hill 2009) along with fellow trader Michael Gross. Their Web site is www.OptionSellers.com.

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