Seasonal trades for dummies

December 27, 2015 09:00 AM

A popular notion among the public (mostly amateur commodity traders) is that you buy natural gas ahead of winter. Gas prices, they reason, will have to rally once it gets cold out, right?

It sounds great, but as with many things in investing what sounds logical is often misleading folklore. The reality of it is this: Cold weather will indeed increase demand for natural gas. It can even have an impact on prices. But both of these are at the retail level. The contract at Nymex is based on the wholesale value of natural gas. 

If you’re looking to put some high percentage option premium in your holiday gift bag, taking the opposite tack of the public in natural gas could be a great bet. In fact, the fundamentals not only suggest that prices will not rally this year, they point to gas prices trading moderately lower by mid-winter. 
Here are four reasons why. 

1. The cycle of natural gas supply & demand

Amateurs, thinking they’ll “outsmart the pros” by buying gas ahead of winter are simplistically naïve. Commercial players eat, breathe and sleep natural gas. Believe me, they are quite aware that it gets cold in winter. 

So aware, as a matter of fact, that they begin building inventory as early as July to have enough supply on hand to meet winter demand needs. This build-up to peak demand period is known as injection season (natural gas distributors are buying gas at the wholesale level and injecting it into storage).

Injection season tends to increase demand for natural gas at the wholesale level and often has been associated with firming natural gas prices.

On the flip side, at some point in autumn, adequate inventories to meet winter demand needs often have been attained. Thus, gas demand at the wholesale level begins to wane, just as it’s ramping up at the retail level. This often correlates to weakening natural gas prices into the fall and winter (see “Counterintuitive price trends,” below). Not surprisingly, the public often can be buying natural gas just as wholesale demand begins to taper off.

 

The chart shows that natural gas prices tend to go up prior to the major heating and cooling seasons and taper off during those higher usage periods. Think of it this way. You and your neighbors buy firewood for winter in the autumn. This spurs demand for firewood. But if you buy enough for the whole winter, you won’t need any more untill next year. Thus, even while you’re burning wood in your fireplace all winter long, the guy selling firewood probably isn’t going to see you or your neighbor until next year. Unless, of course, it is an unusually cold winter. Thus, while you are actually using your wood in the winter, the firewood salesman’s demand will decline after the peak autumn stock-up time.

2. Record supplies

Although storage levels typically are high this time of year, 2015 supply has hit a new record. At 3.929 trillion cubic feet (tcf), the U.S. Energy Industry Administration (EIA) working gas in storage is not only at a record for this time of year, it’s at an historical record. This alone should help limit “cold weather rally” attempts this winter. “That’s a lot of gas” (below) illustrates both the absolute current supply level and the tendency for supplies to build up until the winter heating season begins.

To return to the fireplace analogy, this means your woodpile out back is bigger than it has ever been. Therefore, even if it’s an exceptionally cold winter, chances are you won’t need to visit your firewood guy again. 

3. The trend: Price and economic

The trend is your friend and not just in a price chart sense. Natural gas prices have been entrenched in a moderate but stubborn downtrend since seasonal highs last May (see “No relief in sight,” below). The trend toward higher gas production and an economic “risk off” trend among global investors are not supportive to a sudden price reversal in the immediate term.

4. El nino 

Forecasters at the National Oceanic and Atmospheric Administration (NOAA) noted in its mid-October report that a strong El Nino was in place for the 2015-16 U.S. winter. El Nino is a condition where surface temperatures on the Pacific Ocean rise and lead to warmer winters in the Northern part of the United States. The NOAA temperature outlook calls for warmer temperatures across much of the winter heating regions. It states, “Above-average temperatures are favored across much of the West and the northern half of the contiguous United States. Temperatures are also favored to be above-average in Alaska and much of Hawaii. Below-average temperatures are most likely in the southern Plains and Southeast.” 
If NOAA is right, demand for natural gas will be lower than normal this winter.

Conclusion and strategy

While it’s logical to think that buying natural gas ahead of winter is a good investment, especially with gas at such depressed levels, smart investors can take their cues from the commercial players. While sporadic “cold weather rallies” certainly can occur, overall historical trends favor lower natural gas prices into the heart of winter. Record historical supplies and a global risk-off trend do not favor a counter-seasonal move this year. Thus, the risk of a substantial move higher in natural gas prices this winter is minimal.

Fortunately, the market has driven up call premiums ahead of the winter months. We advise investors to seek far out-of-the-money calls for premium sales on any weather rallies in December and January. That’s how you sell options.  

Option sellers can consider the March 3.40 call for premiums of $500 to $600 (as of Nov. 11). “No relief in sight” shows two substantial resistance areas natural gas much breach before challenging $3.40. This option should not only see good time decay but is also placed above May seasonal highs and longer-term resistance.

About the Author

James Cordier is the founder of www.OptionsSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. He is the author of The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014).