Selling calls should continue to be solid play for Investors
To paraphrase a line from an old Doors song, Natural gas prices have been "down so long that it looks like up." But as is the case with most every commodity, prices are where they are for one reason: Fundamentals.
The discoveries of the Marcellus shale in Pennsylvania and other finds in Texas and North Dakota late last decade were game changers in Natural gas - significantly altering the supply equation. 2012 finds the natural gas market dealing with a supply glut for which demand has yet to catch up. As we stated in The Complete Guide to Option Selling, fundamentals are the name of the game for selling options in commodities.
July Natural Gas Chart Here: Title "July 2012 Natural Gas"
But as we work through the first quarter of 2012, natural gas prices find themselves the beneficiary of a handful of factors that could potentially slow or halt the price slide. Have gas prices finally reached a value level and if so, is it time to sell puts underneath this market? I've searched high and low for a reason to be bullish, or at the very least, less bearish this market. I am here to tell you now - I couldn't find one. Investors reaping profits by selling call options in this market should have no trouble continuing to collect in the first half of 2012.
To discover why, lets examine the three major factors you would want to review for any commodity option sale:
The 3 Dimensions of 2012 Natural Gas
1. Fundamentals: At the time of this writing, natural gas in storage stands near 3.3 trillion cubic feet. This is not a record but hovers near historical highs for this time of year. With prices continuing to drift lower, Chesapeake Energy shook the natural gas market late last month by announcing it was cutting it's spending on Natural Gas
Chesapeake Energy is shifting drilling resources from Natural Gas towards higher priced crude oil in 2012. However, crude oil wells typically still produce natural gas. Despite the move, inventories are widely expected to continue to swell.
drilling in 2012 - substantial because Chesapeake is the country's second largest producer of Natural Gas. While the knee jerk reaction was to buy gas on this news, the reality is that Chesapeake cutbacks will not have much effect on today's burdonsome supplies for months to come - if at all. And if then, less production here could still be offset by other factors. Consider that even most liquid oil wells contain some natural gas. In fact, 35% of new supplies of natural gas come from liquid wells. Industry estimates now see the US at record high natural gas stockpiles come September - even higher than today's burdensome levels.
2. Technicals: As we often point out by repeating the gurus of technical analysis (Elder and Sklarew), for the real picture of a market, look at longer term charts. The weekly chart shows an oversold natural gas market near 10 year lows. For some technicians, that may be a reason to buy. But when a Major new fundamental is in play (such as new supply discoveries) technicals can go out the window. Natural Gas has been oversold since July of last year on a weekly chart. On a monthly chart, it is not oversold at all. Think it can't go lower? Natural Gas traded below 2.00 per mbtu for most of the 1990's. And we didn't know about the Mercellas shale then. At some point, natural gas prices will reach a level where there is simply not that much room to move lower. We just don't think it's there yet.
3. Seasonals: While past performance is not indicative of future results, natural gas inventories tend to get drawn down during the winter months as heating needs throughout the northern hemisphere eat into supply.
This drawing down of supply tends to continue through until April when weather begins to moderate. At the end of the "draw" period, supply is logically at it's lowest point. Lower supplies in storage have historically tended to translate into higher prices on the board.
But it might not help much this year. To begin with, we start 2012 with inventories near record highs. To date, the US has seen an unseasonably mild winter which has kept inventories draws to a minimum. And although it may not seem like it to our Northern readers, April is but 6 weeks away. What happens when we come through winter with minimal draws and supply starts building on top of it again?
Natural Gas inventories tend to erode into March as winter heating needs eat into supply. But 2012 begins with inventories near record highs and a mild winter thus far. What happens in April when supply begins to build again?
I will tell you what happens. A glut becomes a super glut. Gas inventories are likely to test the limits of capacity this year. The fear is that if all storage units are full, some output could be left with nowhere to go. That leaves the potential open for natural gas prices plummeting sharply from even today's low prices, especially as supply builds into the fall. If you are interested in selling options for bigger returns, this is the type of fundamentally biased market you look for.
Conclusion and Strategy
While it is possible that natural gas could see some seasonal price strength over the next 4-6 weeks, we would view all such rallies as Call Selling opportunities. Technically, natural gas is due for a bounce on short term charts. But don't be fooled. The longer term fundamentals for natural gas remain decidedly bearish. With a massive supply overhang that could grow as the year progresses, any rallies in natural gas should be limited in nature.
We would recommend you target call premium at or above the 4.25 strike price level on any February rallies. July and August contracts figure favorably. We'll be doing so with private client group members this month as part of a 6 market premium collection spread. Feel free to call if you would like to be included.
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/Optionsellers.com
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