TAMPA, Fla. (Liberty Trading Group) -- As an option seller, your primary concern in a particular market is not where the market might go, it is where the market won't go. Therefore, if you are considering selling puts in a particular market, your fundamental research should focus less on what factors could make the market move higher, and more on what longer term situations are already in place that will keep prices from falling, at least to the level of your strike price. If enough of these factors are present, you may have a good trading opportunity for an option sale.
Thus is the case in natural gas at this time. The situation is not that the supply vs. demand fundamentals are wildly bullish, it is that the seasonality and general mood of the market appears to be highly slanted against the bears. Natural gas has a mix of psychological and cyclical factors in its favor, which combined, should provide a fairly solid floor beneath prices. It is our contention that puts sold below this floor could be a solid path to profits over the next several weeks. Granted, selling puts is not glamorous in a market whose prices could jump by 20-30% or more given a properly positioned weather concern. Yet put sellers can profit even if a supply threatening storm never occurs, which makes it a more appealing strategy for investors looking for high probabilities over "possibilities."
Seasonally, the time period the United States is now experiencing what is known as the "injection" season. During this period, distributors of natural gas build inventory or "inject" gas into storage in order to have enough supply on hand to meet winter heating needs. Not surprisingly, it is not uncommon for natural gas prices to rally through injection season as distributors aggressively purchase inventory, driving up demand and supporting prices.
The bears are touting the fact that milder temperatures for most of the U.S. summer have allowed inventories to build at a faster pace than normal. The latest EIA storage report shows an injection of 57 billion cubic feet (bcf) into storage last week. This puts total gas in storage at 2800 bcf - 13.5% over the five year average. While this figure is certainly relevant, we advise taking it with a grain of salt. Distributors will continue to accumulate inventory this time of year, regardless of the amount of product in storage. This means that demand will remain firm through October.
A second seasonal factor, however, is the one that most traders have become familiar with over the last two years. Hurricane season in the Gulf of Mexico was once viewed with passing interest by natural gas traders. Storms were an unlikely wildcard at best and traders paid little attention to Atlantic or Caribbean tropical activity unless a storm was right on top of key Gulf of Mexico drilling regions off of Texas and/or Louisiana. All of that changed with Katrina. With 15% of pre-Katrina Gulf natural gas production still offline and destructive images of the storm still fresh in traders' minds, the market will be extremely sensitive to the slightest hint of tropical activity this year.
This sensitivity was illustrated during Thursday and Fridays trading sessions at the NYMEX as prices spiked due to a mere tropical depression in the Caribbean that "could" turn into a tropical storm by Monday. In 2003, traders barely acknowledged a storm unless it was at least a category 2 hurricane inside the Gulf of Mexico. As we now enter the heart of hurricane season in the Atlantic, tropical activity should pick up and at least give traders something to watch over the next 60 days. This alone should be enough to keep natural gas prices from falling substantially.
Bears also point out that crude prices could weaken in the coming months as supplies grow, which in turn could weigh on natural gas. But unlike crude oil, in which the U.S. relies heavily on imports to fill its demand needs, most natural gas used in the U.S. is produced in North America. About 30% of U.S. oil output and 24% of U.S. natural gas production comes from the Gulf of Mexico. What is significant is that the U.S. only meets about 40% of its crude oil demand needs with domestic production. The rest is imported. Yet about 96% of all natural gas used in the U.S. is produced domestically. This means that while natural gas is less vulnerable to geo-political events overseas than crude oil, it remains more vulnerable to domestic threats to supply, such as hurricane damage to Gulf rigs. A storm in the Gulf can have a much greater impact on overall U.S. natural gas supply than on overall U.S. crude supply.
In addition to having a lower percentage of overall supply disrupted, any loss of crude production in the Gulf can be partially compensated for with increases in imports and/or releases from the U.S. Strategic Petroleum Reserves. But because the U.S. imports very little natural gas and has no such strategic reserve for the fuel, there is little that can be done to compensate for lost Gulf production of natural gas.
With bears focusing on higher supply and storm forecasts changing daily, natural gas should experience its share of volatility in the coming weeks. However, it is our opinion that solid seasonal demand and hurricane season beginning in earnest will keep a floor under prices and that any price setbacks will be temporary in nature. If this is true, this would make natural gas an ideal candidate for put selling strategies through September. Look for price pullbacks off of changing storm tracks as opportunities for positioning. This time of year, there is almost sure to be another one building somewhere.
Copyright (c) Liberty Trading Group 2006
James Cordier is head trader and president of Liberty Trading Group, a futures brokerage firm specializing in option writing on commodities. Michael Gross is an analyst with Liberty Trading Group. Please feel free to call (800-346-1949), e-mail or visit us on the web.
