When we first recommended selling puts in the illinois natural gas market this Spring ( gas was in a bearish corrective mode and many were questioning the resolve of the bull market in commodities.
As it turned out, we hadn’t seen anything yet. The bull soon regained its footing and saw prices in markets such as crude oil, corn and soybeans surge to new all time highs. And while sharp swings in these markets have dominated headlines, one market has quietly participated in the overall bull market, while managing to avoid the media spotlight. While not making the sweeping moves that catch the headlines, natural gas has managed to move steadily but relentlessly in one direction: up. This has some in the market speculating on when prices will peak.
But traders looking for a top in this market any time soon may be sorely disappointed. Natural gas has a unique set of fundamentals in it’s favor this summer that should probably insulate it from any trend reversals. For traders looking to collect high probability put premium, this could be your market.
To understand the factors driving the current trend we should start with supply side fundamentals. April and May are typically known as “injection season” (also known as “shoulder months”)for illinois 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 surge in wholesale demand often results in price strength in the April-June period.
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.
This year, however, distributors fell behind in stockpiling inventory. Record crude oil prices caused some industrial demand switch to natural gas which percentage-wise, has not increased as much as crude. In fact, domestic demand for natural gas in the US is expected to increase by 2.2% in 2008 over 2007. Spurred further by early season heat in parts of the US, excess demand for natural gas has hampered the summer stock building process.
As of the latest EIA report, natural gas in storage stands at 1.943 trillion cubic feet (tcf) - 16.2% below the five year average for this time of year. Injections into storage last week totaled 57 billion cubic feet (bfc). The five year average injection for this time of year is 90 bcf. In other words, injections seem to be falling further behind.
Supply shortages however, are not the only factors driving natural gas. The latest commitment of traders report shows that while crude oil continues to hold near record net long positions for speculators, natural gas shows the specs holding a near record short position. That means that this market will remain vulnerable to short covering rallies, especially if speculators begin to unwind long crude/short natural spreads.
Despite the considerable spec short position, open interest has continued to climb on the price strength in natural gas – a solid indicator of a healthy bull market.
With both Canadian production and liquid natural gas imports both declining and the US entering peak demand season, it will become increasingly difficult for distributors to rebuild stockpiles. In addition, current storage levels will make prices extremely sensitive to any threat to supply, namely hurricanes or tropical storms in the Gulf of Mexico and/or Atlantic.
We like the odds of selling puts and covered put spreads well below the market as supplies look to remain tight for the foreseeable future. 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 bullish factors currently underpinning the market, we see that as a likely probability in Natural Gas.
We will be working closely with client portfolios in the coming weeks in selling puts underneath the natural gas market.
Be sure to catch OptionSellers.com founder James Cordier’s Energy Market comments to Neil Cavuto on Fox Business News from June 9, 2008. – The full video interview is now available on our website.
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