With the $100 per barrel crude oil benchmark now breached, the media has finally had its long awaited field day with the “runaway” oil price story. All of the hype has some traders looking to fade the news and short energy markets at current levels. On the surface, this may very well be a good strategy – for the short term. After all, the psychologically significant $100 level will certainly bring out the table pounding politicians eager to “do something” about the “greedy” oil companies obviously responsible for such high prices (oblivious to the fact that it is market forces, not oil companies which dictate the price of oil). In addition, the recent surge in energy prices combined with a variety of discouraging US economic reports has many economists now uttering the “R” word.
The top pickers may have a point and a slowing US economy could certainly put a crimp in demand – especially with prices at $100 per barrel. Our opinion at Liberty Trading, however, is that this bull has legs and any downturns in price will be of a temporary nature (see The New Fundamental in Crude Oil and the opportunity for long term Put Sellers 11/19/07 – www.optionsellers.com.)
It is for this reason that we believe a January correction in energy prices will be an opportunity for put sellers to collect premium. However, the best opportunity to do so may be in the product market – in particular, unleaded gasoline. In addition to the long term fundamentals affecting the entire energy complex, unleaded gas should benefit from a cyclical demand surge in the coming months which should help to insulate prices from any dramatic downswings. This cyclical feature is the subject of this article.
Unleaded Gasoline and Springtime US Demand
One of the more enticing factors of investing in commodities is the seasonal nature of supply/demand cycles in certain markets. In some agricultural markets, planting and harvest cycles can play a considerable role in price direction as fear runs highest during growing seasons while supply runs highest during harvest. In The Complete Guide to Option Selling (McGraw Hill 2005), we make many references to the powerful strategy of selling put or call options in favor of seasonal tendencies.
It is true that past performance is not indicative of future results. Just because prices have moved a certain direction in year’s past does not mean they will move similarly this year. However, if one can determine the fundamental factors that have moved prices in years past and determine if those factors are similar this year, one can utilize that data in making price projections for the current year.
The energy markets, in contrast to agricultural commodities, experience seasonal tendencies based more on demand cycles rather than supply cycles. And nowhere is this demand cycle more pronounced than in unleaded gasoline.
If you live in the Northern Hemisphere, you may have noticed that you often pay more for unleaded gas during the summer months. This is not due to coincidence nor is it due to any magical formula set forth by oil companies. It is basic supply/demand economics. The northern hemisphere summer brings with it what has come to be known as “driving season” in the US and Europe. With warmer weather and kids out of school, the public is more apt to travel. This typically creates a surge in gasoline consumption at the retail level, which in turn, has tended to drive up prices at the pump beginning in May and peaking during the July/August time period.
A key aspect of seasonal analysis is that price tends to precede consumption. Thus, while prices at the pump will tend to rise during the summer months, demand at the wholesale level tends to begin rising early in the year as distributors begin to build gasoline inventories in order to have enough supply on hand to meet summer demand. Thus, in the past, prices on the wholesale level (read futures contracts) have tended to rise in accordance with this increase in commercial demand. Bears pointing out that crude and unleaded are currently “expensive,” take note: These seasonal occurrences have tended to take place regardless of the absolute price of gasoline. Distributors will still need to build inventories, even if gas is at record price levels.
Of course there are other factors that influence the price of gasoline as well. However, during the first half of the year, they are set against the backdrop of this rising Northern Hemisphere demand. In our opinion, seasonal demand alone should be enough to underpin gasoline prices to the point where put selling becomes an attractive strategy for high probability income on a portfolio. However, an overall view of the current fundamentals affecting gasoline prices has convinced us that there are several factors in addition to rising demand that should contribute to higher prices this spring. (For those readers in the Southern Hemisphere, we use the term “spring” and “summer” in accordance to the US and Europe, as we see demand in these regions as the key factor driving prices at the NYMEX.)
Before establishing a bullish position in the market, an investor should first understand the key fundamentals that drive gasoline prices to determine if they are supportive of a favorable market move (or non-move). There are three main factors that will determine the ultimate price of Unleaded Gasoline (or reformulated gasoline blendstock for oxygenate blending “RBOB” as it is now known at the exchange). They are:
- The Price of Crude Oil: As the primary ingredient in Unleaded Gas, Crude prices can obviously have a major impact on Gasoline prices (although this relationship can work in reverse as well). Factors that affect crude prices such as industrial usage, supply disruptions or geopolitical events can have a big impact on Unleaded Gas prices. (While this article is not about the factors affecting crude prices, a thorough discussion of crude fundamentals is featured in the article mentioned in paragraph 2). As of this week’s EIA report, US crude stocks have dropped to 289.6 million barrels – the lowest stockpile levels in three years. Global demand continues to outpace global supply – and additional hedge fund interest in commodities in 2008 is anticipated. Crude may be due for a technical correction and may also see some selling resulting from fears of a slowing US economy. But the underlying fundamentals driving prices are still very much in place and should remain so through 2008.
- Gasoline Demand: As discussed above, wholesale gasoline demand tends to begin rising during the first quarter of the year. However, the longer term demand picture for gasoline appears bullish as well. Despite all the talk of ethanol and a “slowing” economy, gasoline demand remains well above the five year average and even above the consumption levels of 2007, when gasoline demand set a record. The EIA estimates that overall US gasoline consumption will increase another 1% in 2008. Current gasoline consumption is running about 9.25 million barrels per day. Yet, over the last 15 years, gasoline consumption has surged by an average of nearly 9% between early March and peak demand season in late July. An equivalent surge in demand this year would put daily US consumption at nearly 10 million barrels per day, an all time high.
- Gasoline Supply: This week’s EIA report saw stockpiles at 207.8 million barrels – about average for this time of year. However, the US acquires most of it’s gasoline from domestic production and US refinery facilities are antiquated at best. Each year, refinery maintenance seems to take longer and run into more glitches, resulting in more production going offline. This week, refinery operating rate “climbed” to 89.4% of capacity which is slightly above the 5 year average. However, refineries tend to ramp up refinery operation in December to use up excess crude inventories to reduce end of year taxes. We expect to see refinery utilization drop in January as refineries shut down for seasonal maintenance and switch over production from favoring heating oil to unleaded gasoline.
The EIA projects gasoline prices at the pump will average $3.11 per gallon and will peak at 3.40 during the Spring/Summer time period (The EIA is well aware of seasonal demand tendencies) This would equate to roughly $2.60 t0 $2.90 on the wholesale (read futures) level.
While we believe the chances of gasoline trading at the levels mentioned above are good as distributors prepare for driving season, we feel the chances of prices not falling substantially are even better. This is why we believe that put selling is an excellent income strategy to employ over the next 60-90 days in the unleaded gas market. Remember that when selling puts, the market does not have to necessarily move higher for the seller to profit. It only has to remain anywhere above the seller's strike price. It is our opinion that there will be some high probability strike price levels available in unleaded gas in January, but we would advise waiting for corrections to sell premium. High probability traders would want to favor strikes well below the EIA’s 2008 average wholesale price.
As we stated to Bloomberg News this week, we feel crude and unleaded probably are a bit overbought and due for a pullback in the short term. However, we would view this as a correction in a longer term bull market and an opportunity to sell puts far below the current market. We will be working closely with clients in the coming weeks in determining put selling strategies appropriate for different risk tolerances in this market.
Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.
James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
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