Pick up a financial newspaper this week and it looks like Alaska in September – Bears everywhere. Bearish on stocks, bearish on commodities, bearish on the economy. And why not? The economic hurricane we’ve been tracking for the past 16 weeks – wondering how bad it’s going to be - is now making landfall. Unemployment, housing and consumer spending figures are more or less confirming what everybody already knew – we’re in a recession.

Recessions are not pretty - especially this one. Commerce slows and thus demand for goods and services wanes. Nowhere has this been more apparent than in the Energy markets. Crude prices have fallen by more than 72% since their highs in July and Unleaded Gasoline has declined an astounding 76% during the same time period.

On the surface, it looks difficult to make an argument for buying – even at today’s depressed price levels. Today’s nonfarm payroll report was nothing short of dismal. Higher unemployment means less driving and less demand for gasoline. Unleaded Gasoline demand (in the US) is at 8.933 million barrels per day – 333,000 barrels per day below year ago levels. Gasoline demand over the last four weeks is down 3.2% over the same period last year. Crude stocks have piled up to more than 20 million barrels over last year’s stock levels and remain 7.3 million barrels over the 16 year average.

What reason would anyone have to suggest a low is near?

A look beneath surface of these bearish statistics may show that perceptions are not always reality when it comes to fundamentals. It is a fact that US gasoline demand is down by 8.25% since July of this year. Yet prices, as stated above, are down by over 76% during the same time period - a testament to the power of perception. The move down in unleaded gas prices (and most commodities) was not entirely fundamentally based. Funds had built huge long positions across the board in commodities and it took the better part of four months to liquidate those positions. Of course, funds did continue to liquidate because fundamentals along with the credit crisis, continued to worsen. However, open interest in unleaded gasoline indicate that this liquidation had run it’s course by late November. If this is the case, it could mean that the market will begin more closely tracking weekly supply/demand numbers to take its pricing cues.

Granted, these figures have revealed little to change bear’s minds over the past several months. But it is the month of December, a key month for unleaded gasoline distributors and producers alike. Gasoline is a cyclical market and its prices tend to ebb and flow along with its cyclical demand. In the US, gasoline demand and thus prices, tend to be highest in the summer months when more people are driving. However, in the futures markets, there is a key concept to be remembered in price forecasting – Price preceeds consumption.

While demand and thus prices often do tend to be highest in the summer months, the market tends to begin building towards this crescendo up to six months prior to its actual occurrence. During the winter months, refineries begin switching over to a focus on producing unleaded gasoline. This is because distributors on the wholesale level begin accumulating gasoline inventories in order to have enough on hand to meet summer demand needs. This increase in wholesale demand has historically resulted in unleaded gas prices beginning to trend higher in December and continuing throughout the US Springtime. A seasonal chart of unleaded gasoline prices illustrates this phenomenon.

The gasoline supply picture is not a bearish one either. EIA gasoline stocks are now 3.8 million barrels below the 16 year average for this time of year. Compared to year ago levels, the shortfall is even more acute. Gas stocks are now at a 5.1 million barrel deficit compared to last year at this time. 

These shortages have been allowed to intensify because refinery operating rates continue to plunge. Refineries have slowed production of gasoline and distillates in response to reduced demand. Yet, it appears they may be overcompensating. Refineries were only operating at 84.34% of capacity as of the latest report – down 1.82% from last week and down considerably from the 5 year average of 91.6% for this time of year. This has allowed gasoline stocks to fall and crude stocks to accumulate.

Refining capacity cannot be brought back online overnight. If wholesale demand does begin to pick up into January, refineries could be caught “flat-footed” and leave the market undersupplied with gasoline.

The market itself appears to already be anticipating a demand build into early 09. The spread between near month and June 09 gasoline has reached life of contract highs with a full .30 cent premium of June Gasoline over January Gasoline (See spread chart below).  This shows that traders are expecting the price of wholesale cash unleaded gasoline to be .30 cents higher in June than they are today.  While there is usually a positive spread between Spring and Winter contracts, this one has become extreme and could hint that near term prices have perhaps become overdone.

We at Liberty Trading stated that it would be hard to make an argument for buying the market here, and therefore, we are not going to make that argument. But selling options? That’s another story.

If you buy the market here, it could continue lower and in that case, you would probably lose money and possibly get stopped out. While there is reason to believe that the market may be approaching a low, we are not bold enough to step in and but the futures.

If one chooses to sell the puts however, one can not only take advantage of inflated premiums now available in the options, one can sell at strike prices substantially below today’s market price for unleaded gasoline. That means that even if prices do not forge a low tomorrow or next week, one can remain in the trade and give the market needed time to begin a seasonal ascent.

It is not our opinion that prices are coiling for a major bull surge into 2009. It is the opinion of some that speculators carried this market far beyond it’s true price this summer and now prices are coming back in line (and then some) with their true fundamentals. We happen to be of this opinion. It just so happens that the true fundamentals are looking a little brighter than the media would have us believe (at least for gasoline). With all of the doom and gloom we hear each day, US gasoline demand is down 3.2% over last year at this time.  That certainly doesn’t sound like a demand disaster and proves once again that gasoline has a certain inelasticity in it’s consumption trends.

While we won’t predict the next great bull market in unleaded gas, we do see the rate of price descent slowing and expect the market to begin forging a seasonal low over the next several weeks.  Fortunately for put sellers, that is all the analysis we need for a successful trade.


Figure 1: January Unleaded Gas (RBOB)



Figure 2: June Unlead vs. January Unlead

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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