From the May 01, 2010 issue of Futures Magazine • Subscribe!

How to trade natural gas now

If you liked it at $6, you should have loved it at $5. You could have “backed the truck up” at $4. So now what do you do with prices sporting a “$3” handle?

Natural gas and natural gas stocks have been the darling of several high profile media pundits for going on 18 months. It’s the “fuel of the future” and “rapidly developing” technology will soon mean new avenues of demand. “Buy it now” they say, “quickly, before it goes back up.”

If you had followed that advice, chances are you’d be eating your losses now. Natural gas may very well be the fuel of the future, and its prospects down the road as an alternative fuel are looking brighter. However, in the near-to-intermediate term, the fundamentals are a mess. And future increases in demand may be offset or exceeded by future streams of supply.

To put it simply, we are in the midst of a natural gas supply glut — one that will not be rectified anytime soon.

The unnamed gentlemen mentioned above are well respected by the investment community and cannot be blamed entirely for miscalling the natural gas market. Gas prices were sacked by two simultaneous occurrences that drastically altered their price path, neither of which whose impact could have clearly been foreseen. These two forces combined, quite coincidentally, at the same time:

1) A recession-led dip in demand, which hurt many commodities. Natural gas was hit particularly hard as it derives a large part of its demand from the commercial sector as opposed to the individual retail sector.
2) A rapid expansion in the current and future supply of natural gas.

It is a revolutionary shift in the way natural gas is extracted from the Earth that has reshaped the fundamentals of the market for good. The process is known as hydraulic fracturing and horizontal drilling and it allows drillers to access natural gas trapped in shale rock formations. This new process has resulted in massive discoveries of new natural gas wells in the continental United States. Notable examples are the Barnett Shale in Texas and the Marcellus Shale in Pennsylvania and New York. These once inaccessible supplies have come online just within the last few years and it is estimated that these, along with other new shale rock discoveries, possess enough new supply to power the United States for the next 100 years or more.



The Barnett Shale alone accounts for 7% of American gas supplies. This new output resulted in more than 600 billion cubic meters of U.S. production in 2009. Almost in tandem with the surge in American output, the recession resulted in a 3% drop in U.S. demand for natural gas in 2009. European demand dropped by more than 7%. This has allowed near-term supplies of natural gas to accumulate, putting them near historical highs for this time of year, just as winter demand is waning (see “A little gassy”).

Natural gas supplies have just reached the point of the year where on-hand supplies are typically at their lowest. Consequently, this often results in a time of year when prices will be at their highest. That has not happened this year.

Perhaps this is due to the relative glut of supply on hand. Perhaps it is institutional traders' unwillingness to buy a market where a whole new avenue of supply has just opened up. This doesn’t happen very often.
Regardless, spring is the time of year when on-hand inventories start to build as the peak winter demand season has passed. This has often been associated with price weakness.

The question is, if natural gas cannot put together some kind of rally when prices are near what is generally the lowest point of the year, how are they going to respond when supply starts to build ? Even if you assume a moderate demand recovery in 2010, it will take a long time to eat down inventories to levels anyone would consider “bullish.” And 2010 is expected to produce record output.

Of course, there will be rallies in natural gas, but we expect these to be limited. Given the supply issues facing this market, any such rallies will serve as opportunities to short the market.
The bold can look to short futures on 50¢ to $1 rallies, but make sure to use wide stops as natural gas prices are already near historical lows. The profit potential could be limited.

A preferable strategy may be to sell deep out-of-the-money calls in the back months, looking to take profits in 60-90 days on time decay. We like strikes above $8, which gives the market plenty of room to move without threatening your strikes. For this trade to work, all you would need is for prices not to rally substantially over the next few months.

James Cordier is the founder and head portfolio manager of Liberty Trading Group/OptionSellers.com. Michael Gross is an analyst with Liberty Trading Group. Together they wrote “The Complete Guide to Options Selling” (McGraw-Hill 2009). They can be reached at www.OptionsSellers.com

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