Jim Cramer has been a natural gas bull now for something close to a year. We're not knocking Cramer, but even through the economic crisis, a rapidly declining stock market and falling energy prices, there has been a stubborn group of newsletter authors and media pundits that continue to tout the "coming bull market" in natural gas. They liked it at $12 per mbtu. Looked like a bargain at $10. Underpriced at $8, a "buying opportunity" at $6. Now, with prices trading under $4 per mbtu earlier this week, I'm sure they'll feel we've finally reached the "true" value level.
The crux of the bullish argument is that natural gas continues to gain ground on the "old fashioned" petroleum products as far as overall consumption. Gas is cleaner and cheaper to produce than crude oil and its products. Newer homes and factories are increasingly choosing natural gas for their heating and other energy needs. In addition, natural gas has been an early beneficiary of the popular push towards alternative fuels. The US has plenty of it, and T. Boone Pickens thinks it's the answer to our energy woes. What's not to like.
They may very well have a point. However, correlating this growing industry with rising prices and timing an investment opportunity is like trying to shoot a moving ping pong ball with a rifle. More importantly, most of these bulls didn't count on a demand-stomping recession.
Natural Gas may very well have a bright future ahead of it from a long-term standpoint. But then again, so might Citibank. Do you want to buy that right now.
As an option seller, you are only concerned with how to make money in a market over the next 90-120 days. If you sell options and the market moves in your favor, perfect. If it doesn't move at all, just as good. If it moves against you - still a good chance you'll make a profit. As an option seller, you just need to keep your premium. Nothing fancy here. A nice, quiet market with limited near-term upside will do just fine.
And as far as the near term goes, Natural Gas is one market that appears to fit the bill.
Seasonal Strength Seems Lacking This Year
In normal years, natural gas has often enjoyed price strength in the first half of the year as annual inventories become depleted as the winter heating season draws to a close. Usually by April, distributors in the US will again begin to accumulate inventories to meet summer demand needs. Natural gas is used in many electrical generating facilities which often see a surge in demand due to summer air conditioning usage. This period of accumulation is called "injection season" and it is typically when we start to see natural gas inventories rise again.
Historically, (while past performance is not indicative of future results) prices have tended to correlate to this cycle of falling and then rising supply. It has not been uncommon to see prices gradually rise from January through April as winter stockpiles are drawn down. Prices will often peak in the March-May time period and then begin to decline again as inventories build into the summer. It's basic supply demand economics. Lower supply means higher prices and vice versa.
This year, however, prices have not yet begun to rebound. In fact, prices have moved quite counter-seasonally - declining by nearly 33% since January 1st.
What's Going On?
To answer bluntly, a recession. It's not that it's been a particularly mild winter in the US. It's simply that people are turning down the heat to save money. Factories are cutting back production and labor. We're simply not using as much gas.
As a result, consumer natural gas demand in the US is expected to drop by a full 1% in 2009. Industrial demand, however, is projected to slump more than 5%. This is not surprising when one considers overall US GDP is projected to contract by 2.7%.
This lack of usage has slowed the withdrawal of natural gas from storage this winter. As of the latest EIA report, working gas in storage stood at 1.895 billion cubic feet (bcf) as of the week ending February 20th. This pegs supply at levels 14% above this same time last year and 11.7% above the five year average.
Obviously, burdensome levels of supply coupled with expectations for further declines in natural gas demand have more than offset the normal seasonal withdrawals in investor's minds. This is why gas prices have continued to plummet.
Outlook and Investment Strategy
With injection season still a month away and natural gas charts indicating oversold levels, it is entirely possible for prices to experience a rally at some point in March. However, with injection season likely to begin with supplies at burdensome levels and demand projected to slacken further in 2009, we feel natural gas will have an uphill battle in putting together any significant price gains over the next 8-12 weeks. If prices cannot rally during this period of seasonal draws, how are prices going to react when inventories begin to build again in April?
With July Natural Gas trading near $4.50 mbtu this week, attractive calls strikes are available at nearly twice the current value of the commodity. Aggressive investors may wish to begin establishing call positions at these levels. We at Liberty Trading feel the more conservative route may be to look for rallies over the next 10-20 days as opportunities for selling more distant call strikes. Premiums remain healthy through the June and July contract months.
Liberty Trading will be working closely with clients over the next several weeks in establishing positions in this market.
Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.
Figure 1: EIA Working Gas in Storage
Figure 2: July Natural Gas, March 2, 2009
James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group/Optionsellers.com
Optionetics.com ~ Your Options Education Site
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