Once the weather turns warm up north, attention of weathermen and natural gas traders turns to hurricane season. That only intensifies as kids head back to school in September. In fact, according to the National Oceanic and Atmospheric Administration, the maximum hurricane activity is in early to mid September.
In Florida, the media is already in panic mode. The national financial media's seasonal theme is that hurricanes will wreak havoc on Gulf oil and natural gas rigs. As the United States gets much of its domestic production of natural gas from Gulf rigs, who knows how high prices could go?
It seems pretty simple: buy natural gas in the summer and fall, wait for the hurricanes and get huge profits. But alas, expecting the spectacular is seldom a wise investment decision.
Had you followed this strategy for the past decade, chances are you would not have fared well. Gulf storms that do enough damage to rigs to significantly disrupt production are extremely rare. Hurricane Katrina and to a lesser extent, Rita, were exceptions. Granted, they can happen and their possibility should not be discounted. However, banking on them to happen is more like playing roulette.
The media hype surrounding hurricane season brings out the public to trade natural gas. And the public’s favorite tool for trading volatile markets is buying options.
Natural gas prices have continued to flounder for most of the year due to hefty supply. New discoveries in Texas and Pennsylvania have opened the door to long-term future supplies, changing the big picture supply dynamic for natural gas.
At 2.891 billion cubic feet in storage, natural gas supplies remain near historic highs for this time of year (see "Plenty of breathing room"), which will be the prevailing headwind the bulls will have to overcome. Total storage levels remain nearly 10% above the five-year average for this time of year.
But the bulls do have a few bullets to use. A late July Energy Information Administration report showed a 10% jump in natural gas used for electric power. Overall U.S. natural gas demand was up 4%. Both of these figures were most likely the result of the heat wave that swept much of the nation in July.
Tropical Storm Bonnie, the first storm of the season, threatened Gulf natural gas rigs but was quickly a non-event.
Natural gas rigs are built to withstand the ravages of the ocean. To knock one offline for any amount of time requires a direct hit by a catastrophic type of hurricane, one of Katrina magnitude. It's not impossible, but it's rare. In the past, when supplies were tight, a series of near-miss storms that could cause a cautionary but temporary disruption in production was enough to cause a spike. Currently, however, supplies are ample.
Bonnie brought out the public buyers of natural gas in July but was soon gone but not forgotten, as there is always the next storm. We are not in the business of predicting the daily direction of natural gas prices, but finding opportunities in mispriced options premiums.
The tendency to load up on options in case of a major weather event, hoping for a home run trade, creates opportunity. To that end, selling deep out-of -the-money options appears to be a solid strategy in the current environment. Recent volatility due to fund buying and storm coverage has inflated option premiums on both sides of the market. Late season electricity demand and future impending storm threats should be enough to keep the market supported. Yet, the market’s continuing supply overhang should serve to temper any short-term bullish enthusiasm.
The exception here would be a true Katrina-like storm moving into the Gulf, at which point closing any short call positions is the safe choice.
We like selling puts on weakness and calls on strength to take advantage of current volatility. This is the time of year where call premium can often be found at absurd price levels. Rapid time decay often can be the norm in this situation, especially if there is no storm activity for two to three weeks in September as we near the end of the hurricane season.
Volatility is the main factor that creates overpriced options. Late summer and fall are often the best months for finding this in natural gas.
James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing exclusively in selling commodities options. Michael Gross is an analyst with Liberty Trading Group/OptionSellers.com. Cordier and Gross wrote "The Complete Guide to Option Selling, 2nd Edition" (McGraw-Hill 2009).
More from Cordier and Gross:
How supply/demand affects gasoline prices
Selling puts to exploit bullish fundamentals