How to trade this gas buying season

March 20, 2016 01:00 PM

With all of the recent media coverage of the crude oil market, you may have forgotten about the long lost, neglected cousin in the energy markets: Natural gas.

Like its more famous relative, it has been plagued by high supplies and low prices. But unlike the crude market, it doesn’t get the glamour. 

For traders, that’s just fine because natural gas has one of the most consistent seasonal tendencies of any commodity. While crude is a global market, the United States meets most all of its domestic gas supply needs from North American production. This can make supply-side price analysis a simpler matter. But for seasonal traders, demand is what drives the car. And this car could be getting ready to make a hard left turn.

The real seasonal in natural gas

Seasonal tendencies can play an important role in markets. The problem is, most traders and investors don’t understand seasonal tendencies and what really makes them work, and in some cases not work. 

As we explained in “Seasonal trades for dummies,” (January, Modern Trader), neophytes may assume that gas prices should rise in winter time because that is when demand is highest. But that is most often not true. Why? Because in commodities, price precedes consumption. Commodities futures prices at the Nymex and other futures exchanges most often take their cues from wholesale supply and demand, not retail supply and demand. Thus, as we explained in our January article, wholesalers begin building inventories for winter in late summer. Wholesale demand (and thus prices) are most often stronger in the fall. 

By winter, inventory targets usually already have been achieved. This means wholesale demand (and thus prices) ironically often weaken right when retail demand is ramping up (despite media focus on how “cold” or “warm” it is this week). For the most part, this held generally true in late 2015, early 2016. 

Therefore while you may still concern yourself with icy roads and shoveling snow, the natural gas market is already starting to think about summer.  

As early as March, wholesale distributors once again begin accumulating inventory to meet excess electricity demand in the summer, primarily because of increased electrical consumption from air conditioners.

This period of wholesale supply accumulation is known in the industry as “injection season” – aptly named as this is when new gas is being injected into storage tanks. 

Injection season often has been associated with rising natural gas prices. This often has proven true regardless of the absolute price of natural gas or the absolute level of supply currently on hand (see “Injecting price,” below).

A bullish technical set up

In addition to historical price tendencies, natural gas is exhibiting a classical bullish formation (see “Is reversal at hand?” below). While we don’t place an inordinate amount of weight on technical set ups, this classic inverted head and shoulders formation certainly coincides well with the seasonal tendency. 

It’s hard to make a bullish argument for natural gas supplies right now. The latest Energy Information Administration (EIA) figures put total U.S. storage at 2.934 trillion cubic feet (tcf) - 17.9% above the five-year average and near a historical high for this time of year (see Plenty of gas,” right).

However, as we learned earlier, natural gas supplies ebb and flow with the seasons. Right now, we’re approaching (believe it or not) the end of the winter heating season. This is drawing down natural gas stocks. By March, distributors will begin re-stocking their inventory. This transition period from falling to rising wholesale demand has been most responsible for spring price increases in years past.

Outlook and strategy

Natural gas has a strong seasonal tendency for higher prices in the spring. An impressive chart pattern is hinting that prices may be exhausted on the downside and ready to begin moving higher. Does this mean the next great bull market in natural gas is around the corner? Probably not.

Burdensome outright supply will be a headwind for natural gas bulls for some time to come. Like crude oil, natural gas production in the United States has surged in recent years. And 2016’s El Nino has brought warmer than normal temperatures to much of the United States this winter, despite some high profile winter storms. This will be enough to give bulls some pause.

At the same time, seasonal patterns have tended to hold true regardless of outright supplies. So what is an investor to do?

This is not a market to trade the futures. While seasonals and charts point higher, this market is still subject to downdrafts, especially given the supply situation. 

How to proceed? You can profit not only by picking what the market is going to do, but by what it is not going to do. Natural gas prices are already near 16- year lows. It’s hard to see them making a sustained dive lower heading into peak spring demand season. 

For that reason, selling puts beneath the November lows looks like a solid strategy at this point in the cycle. We favor the July and August contracts for best balance of premium vs. time decay.

Volatility could be better for option sellers right now so we recommend waiting for pullbacks to take premium. Selling puts, however, gives the market plenty of room to move and still keeps you in the game long enough to take advantage of a seasonal push higher – or simply a stabilization of prices.
That’s high odds investing.

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).