Commodities Roundup: Natural Gas
March 24, 2008
A wave of selling washed over commodities markets this week as long speculators took notice of the Fed’s recognition of inflation. With a rate cut of only ¾ point (many investors were expecting a full point) and a nod towards inflation worries, the Fed effectively stopped, at least temporarily, the slide in the dollar. A rising dollar was enough to send many commodity bulls to the exits and prices tumbling. While the commodities bull market did and continues to have a fundamental basis, too much speculative money chasing certain markets can cause a disconnect between fundamental values and prices. Sooner or later, prices will have to come back into line with the underlying fundamentals. This week, the chickens came home to roost.
It remains our opinion that this week’s selling, while considerable, is a correction in a longer term bull market. These types of corrections can make a bull market healthier in the long term, and it may not be too early to go bargain hunting now.
In searching for markets that may make good value plays, one would search for a commodity that has positive fundamentals, but one that performed relatively well in the current sell off. One such market is natural gas.
While gas prices were not immune from a price slide this week, they managed to hold up relatively well to bearish external pressure, managing to close in positive territory on Friday. It was one of the few markets that closed positive on the day when most markets were still in liquidation mode. This should put it in a solid technical set up over the next 1-2 weeks.
But natural gas has a unique set of fundamental factors that may have helped insulate it front the brunt of the bearish forces.
April and May are typically known as “injection season” (also known as “shoulder months”)for natural gas as distributors accumulate inventory to meet summer cooling needs (natural gas is used to fire electricity generators used to meet the increased load demand brought on by air conditioning use). Thus, while demand at the retail level tends to wane in the Spring, wholesale demand is just ramping up. This expected surge in wholesale demand may be playing a role in supporting prices.
The rule is this: Price precedes consumption.
What this means is that price tends to rally in anticipation of consumption and not necessarily once the excess usage has begun. Why is this so? This is because in order to provide the excess supply to meet the heavy demand on the retail level, distributors must begin buying aggressively in advance of the actual retail demand season. Therefore, demand on the wholesale level begins to increase in advance of the peak usage seasons. Thus, these time periods are often accompanied by a corresponding increase in prices.
These types of cyclical tendencies tend to occur regardless of the absolute price of the underlying commodity. For summer “cooling season”, distributors tend to start accumulating inventory 2-3 months ahead of the beginning of peak usage in June.
Current supplies of natural gas are also playing a role. Natural gas prices floundered in late 2007 as supplies remained near 5 year highs at year’s end. However, the supply situation has reversed as producers eased off production and winter heating needs have exceeded expectations. Today’s EIA report showed an 85 billion cubic foot draw from natural gas stockpiles for the week ended March 14th. That leaves the nation with 1.313 trillion cubic feet (tcf) in storage – over 14% below last year’s levels at this time.
The longer-term picture for Natural Gas is one of demand outpacing the industry’s ability to meet it. Demand for Natural Gas in North America is increasing at about 3% per year, while production is only increasing 1% per year. Older wells are being depleted and newer wells are not producing as much. This fundamental is illustrated clearly in a long-term chart. Since 2001, Natural Gas prices have embarked on a steady, albeit volatile, uptrend as the construction boom in the US means more households using Natural Gas to heat in winter and cool in summer. Natural gas is the fuel of choice for new homes and industry as it burns cleaner and cheaper than coal or heating oil. For this reason, the trend of demand outpacing production is expected to continue.
Figure 1: Natural Gas, April 08
All of this does not necessarily mean that the lows are in - in Natural Gas. Macroeconomic selling pressure could still weigh on the market in the near term. However, we feel that with the longer term picture coming into focus and a seasonal tendency now coming into play, the market will have a hard time moving substantially lower. This may not be the perfect situation for a futures trader who could risk getting stopped out too soon on a long play. But it could be an ideal set up for an option seller.
We at Liberty Trading like the odds of selling puts and covered put spreads well below the market as accumulation period begins in earnest next month. Remember that with put selling, the market does not necessarily have to rally to produce a profit. It only has to keep from declining sharply. With the market appearing to have digested the near term supply data and bullish rumblings on the horizon, we see that as a likely probability in Natural Gas.
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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