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The month of July witnessed a precipitous decline in the price of natural gas that has many wondering if prices ever move anywhere other than down. But the pace and scope of the selloff has had the same effect on the market as a natural forest fire can have on the long term health of the forest. It brought prices back into equilibrium.

Nat Gas was one of the stars in a variety of bull markets that took commodities prices to all time highs this Spring. With oil prices at all time records, a shortage of gas in storage and liquid natural gas being pitched as the fuel of the future, the futures contract became a speculator and fund favorite. The hoopla that generally surrounds the “official” start to hurricane season often brings in additional spec buying which added an extra layer of froth to this market. But specs are a fickle crowd and as a mild summer began and natural gas stocks started to build, the longs began to liquidate. And liquidate they did, with gas prices tumbling nearly 30% within a three week period.

The correction was justified. However, as markets often do, natural gas prices may have overcompensated a bit and now could be approaching a longer term value level for put sellers. In fact, fundamental fair value for natural gas is probably at or above current price levels. A series of outside events are most likely artificially extending the downside momentum in gas. Mild US summer temperatures, government investigations into hedge fund energy trading and a general liquidation trend in commodities over the last several months have all added to natural gas’ price woes.

But if one peels off the superficial factors, natural gas has a number of fundamentals working in its favor that put sellers should begin considering now.

The latest EIA storage report for natural gas released on July 31 showed a 65 billion cubic ft storage build for last week. That was below analyst’s estimates and was construed as mildly supportive for prices. However, the bigger picture shows that with 2.461 billion cubic feet in storage, we are still below the 5-year average and 12.7% below year ago stock levels. Hurricane season begins in earnest during August which should make shorts begin to grow hesitant over the next few weeks. More importantly, August typically marks the seasonal time period when distributors begin accumulating inventory in order to have enough on hand to meet winter demand needs. This typically creates higher demand at the wholesale level and is often supportive to prices.

While we now should be approaching fair value for natural gas, prices may still have some liquidation left in them before we reach a true bottom. A price decline down to the 9.00 level is still not out of the question for the December contract (see chart). This is why we recommend selling puts.

Remember, as a seller of puts, one only needs the market price to remain anywhere above his strike to eventually be profitable. Thus, prices do not necessarily need to move higher for a successful trade.

We at Liberty Trading like selling the December puts at strikes below the 6.80 level as a solid value play in natural gas. If at option expiration (in November), natural gas prices are anywhere above the strike price, the option expires worthless and the seller keeps all premium collected as profit.

The benefit? The seller of the put does not have to pick the absolute bottom in natural gas prices. He is only picking a level far beneath the market that he feels it cannot attain. Given the fundamentals that face the market in the upcoming month, we feel it to be a fairly sound investment.

Figure 1: Natural Gas: December, July 31 2008

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
Questions for James and Michael? Visit the Optionetics.com Discussion Board

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