James Cordier & Michael Gross
May 4, 2009

One of the many, many benefits of becoming an option seller in commodities is that you don't always have to be looking for the next "hot" market. You don't have to analyze 1327 different stocks to find the one that will surely "take off" in the next quarter.

If you are in the business of looking for the next Google, you most likely discard dozens, hundreds, or even thousands of "dogs" in your quest for your diamond in the rough. By "dogs" I mean stocks with lackluster fundamentals, uninspiring price action and little reason to move more than marginally higher. In equities, you might toss these "dogs" aside by the handful.

In commodities, if you are an option seller, you would probably call this same type of market an "income stream. "

In fact, you would look for the market with the most lackluster fundamentals, the worst price action with the least reason to move higher in price.

You would look for a market like Natural Gas.

I started this week's article the way I did because we have covered Natural Gas often in the past few months. Each time, we have discussed how the lackluster fundamentals in this market should limit upside price movement and how you can sell calls and take in premium.

A few readers (always non-clients) will write in and offer feedback such as "nice article on the Gas but would love to see you comment on Sugar, Platinum or Lumber. Why do you often focus on a few markets and ignore others?"

The fact is that I am not "ignoring" anything. Our objective here is not to present full coverage of every commodity on the board. Our objective is to show you where we think the best opportunities are. Why recommend writing options in sugar if we think the better opportunity is to simply go to the well again (so to speak) in Natural Gas?

In the portfolios I manage for clients, we diversify over a select group of diversified commodities. But if a market such as Natural Gas is under pressure all year from the same fundamental factors, there is no reason we cannot siphon premium from that market all year long. We don't need the superstars here. The dogs will work just fine.

Because for every dog that seems to stay trapped in a listless price movement, there is always a group of traders or investors who think it's going to move or at least want to hedge against the possibility that it might. I often get the question, "Who is buying these far distant calls? - It's double the price of Natural Gas - who would buy that option?!"

You'd be surprised.

Speculators are always around. Who knows why they buy these far distant strikes. In Natural Gas, we have plenty of willing buyers for the calls we sell at these levels. They obviously aren't looking at the same fundamentals we are - or perhaps they are. Hedge funds, commodity pools, commercial gas distributors, producers, drillers and small individual speculators all use the futures markets and not for the same reasons. They may have complex hedge strategies that involve buying these calls in combination with other options or contracts. They may be offsetting other positions. They may be hedging against price surges as per company policy. Or, they may be traders looking at a technical formation, some trading system they read somewhere, or reacting to the advice a broker gave them such as "buy before hurricane season."

All of this is irrelevant to us and to you, should you choose to sell options. Because when you strip away all of the reasons, motivations and double dipped Fibonacci/Gann criss-cross lines, it is core supply demand fundamentals that will ultimately determine the fair price for a btu of Natural Gas. Natural Gas cannot be "bid up" by a group of chat room buddies that decide to buy it at the same time. Natural gas cannot go bankrupt. Natural gas is not going to miss its earnings target. It's the supply/demand fundamentals that commodities markets answer to. And the fundamentals for Natural Gas right now remain lackluster at best, and possibly just got a little more dismal. This is good news if you are a call seller. Below is a summary of the existing fundamentals and a suggested strategy for capitalizing on this "boring" market in Q&A format.

Why are Natural Gas Prices so low? 

To put it simply - a supply glut. Manufacturers ramped up drilling and production in 2008 in response to record energy prices, increasing US gas output by 7.2% for the year. When the economy slowed, we were left with a "hangover" of excess supply that continues to plague the market. Despite the sharply lower price of Natural Gas in 2009, this production trend has continued with gas production up 2.1% for the first two months of 2009. This in contrast to a 4.7% drop in consumption during the same time period. As we projected in our February report, supply overruns have continued to build. As of the latest EIA storage report, nat gas in storage was pegged at 1.695 billion cubic feet (bcf) - near an all-time high for this time of year, 34% above last year at this time and 22.5% above the 5 year average.

Why should Natural Gas prices stay low? 

Because it will take some time to work through the burdensome stockpiles. Despite producers finally beginning to curtail new drilling in the 2nd quarter, it could be late 2009 before supplies begin to recede back to even average levels. More bad news for the bulls, is that Natural Gas just shifted from one key cyclical phase to another. "Drawdown" season in the US has just ended and "injection" season has just begun. During winter months, end users and distributors tend to "draw down" the Natural Gas supply in storage in order to meet winter heating needs. At the end of winter, Natural Gas supplies tend to reach a cyclical low for the year. At this point, producers begin a seasonal effort to replenish supply levels by "injecting" new gas back into storage in preparation for summer cooling needs (Natural Gas is often used to power electric plants - more of which is needed during the summer months to power air conditioners). Prices will often strengthen during drawdown season (as supplies dwindle) and weaken during injection season (as supplies build). However, where supplies fall in the historical spectrum can also play a role - as we can see this year. As supplies remained near historical high levels in 2009 (for this time of year), prices continued to falter even in drawdown season. As April 1st marks the unofficial beginning of injection season, we are once again seeing supplies begin to build. Our question is, if prices cannot rally when they are "supposed" to (when supplies are falling), how are they going to rally when supplies are building - a time of year when prices have been historically weak? It's hard to see it happening.

Gas bulls touting the fuel as the energy of the future may be right. But translating that to substantially higher prices may be a different story. Anybody who read Thursday's (April 30) front page of the Wall Street Journal may see why. Aside from a comment on how the US is now "swimming" in Natural Gas supplies, it reports on the discovery of the Haynesville Shale, a dense rock formation in Louisiana that could hold as much a 200 trillion cubic feet (tcf) of Natural Gas - an amount equivalent to 18 years worth of US oil production. With new discoveries in other states such as Texas and Pennsylvania, the Journal suggests the US could be sitting on as much as 2200 trillion cubic feet of Natural Gas, enough to power the country for 100 years. While this has little impact on prices in the near term, the front page of the Journal can set a psychological precedent in trader's minds.

What could make Natural Gas prices move higher? 

Any number of things could make it move higher. Technical breakouts, an impressive news story, a heavy round of fund buying. But these types of moves are almost always limited in scope. To get a real trend changer, one would need a radical change in fundamentals. A hurricane could provide some price strength. But the chances of a hurricane causing any real, lasting supply disruptions are slim. Katrina was the exception, but Katrina was the perfect storm hitting the perfect bullseye - a once in a generation storm. Additionally, storm season in the Gulf of Mexico does not begin in earnest until late July or August. Last year's muted reaction of gas prices to storm threats illustrates that traders have caught on to this fact and don't bite as easily on weather reports any more. This is not to say Natural Gas prices cannot rally. It's just to say it's hard to see them beginning a longer term bull market without a radical shift in either supply or demand - something we see as unlikely for at least several more months.

How can I capitalize on this market? 

Our opinion here at Liberty Trading remains the same. Sell calls. Sell deep out-of-the-money calls and collect the premium. Selling calls allows one to position far above the current price of the commodity. As long as the strike price is not reached prior to option expiration, you keep the premium collected as profit. This allows the market to experience limited rallies without substantially affecting your position.

With prices down 40% from last year's levels, any downside price movement will be more likely of a grind than a sharp drop. Yet, there appears to be little fundamental impetus to move the market substantially higher anytime soon. With the majority of speculators almost always favoring the long side, call strikes remain available way above the market.

A lackluster, fundamentally bearish market with a large supply of call buyers willing to pay out premiums. Sounds like my kind of Dog.

 

Figure 1: Natural Gas Sept 09 

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
Optionetics.com ~ Your Options Education Site 

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• May 4, 2009
  Commodities Roundup: Natural Gas