Target Fat Option Yields from the “Natural” Flow of Springtime Gas Prices
Natural Gas Prices Have Cooled Down with winter temperatures. Here is how to potentially pocket high option premiums as Springtime fundamentals kick in
Our October 28th advisory suggested the counter-intuitive play of selling call options as natural gas prices headed into winter. Natural gas prices subsequent run up to $4.00 per mbtu did not diminish the significance of seasonal weakness as the new year began. March contract Natural Gas prices dropped by nearly 25% from late December through early February.
This only re-enforces two notions from the book that commodity option sellers must become familiar with if they wish to establish reliable forms of cash flow:
- Seasonal price tendencies are powerful, but inexact. Trying to time their occurrences to a single day or week is futile. This is reason 1 why you sell options in commodities – your timing doesn’t have to be perfect.
- The ability to sell deep out of the money strikes in commodities gives you a substantial advantage over stock option sellers. Use it! In the October piece, we suggested selling the March $5.50 calls. Even with the price rally to $4.00 per mbtu in December, the $5.50 strike was never threatened. The March $5.50 call is now all but worthless, and will expire on February 23. This is reason 2 why you sell options – even if the market initially moves against your position, you have plenty of leeway to “ride it out” and wait for fundamentals to do their thing. With prices back near $3.00 per btu basis the March contract, they have certainly done that.
This brings us to the Natural Gas market in February, and the next potential opportunity in this market.
The Natural Ebb and Flow of Demand
As we explained in our October piece, natural gas prices at the wholesale level are often at highs as the winter begins. Thus, distributors have little need (and sometimes little room) to store any more. Demand at the wholesale level then, can suffer – right when retail demand peaks (in mid-winter). This simple yet potent function of economics seems to have been responsible for the price drop again in early 2017.
But in the Springtime, these factors reverse. During the winter months, wholesale inventories of natural gas decline as usage at the retail level (About 48 percent of all U.S. homes use natural gas for heating, while electricity is used in 37 percent – often produced in plants running on natural gas.) eats into storage levels. Winter then, is known as “draw” season for natural gas as inventories tend to get “drawn down” from increased cold weather usage.
Natural Gas storage levels tend to hit annual lows at the end of winter, when supplies are depleted. Inventory levels for the past 5 years (above) confirm this. 2017 Natural Gas Supplies are currently lower than last year at this time, but appear to be tracking right in line with averages.
Because of this, supplies tend to reach their lowest levels for the year at the end of winter or early spring.
Price Reaction to Annual Supply Lows
Consequently, as dictated by economics 101, prices will tend to be highest when supplies are at their lowest. As the seasonal chart below seems to suggest, this has most often clearly been the case with Natural Gas.
As Natural Gas Inventories tend to hit lows for the year in late March/early April, Natural Gas prices tend to strengthen to reflect the limited supply.
In addition to strengthening prices in the Spring, prices have tended to stay firm right into summer, even as inventories start to build again.
2017 Supply Levels More Bullish
As of the latest EIA inventory report, natural gas stockpiles sit at 2.711 bcf – 8.9% below last year at this time.
Longer term fundamentals appear to be shifting to a more bullish posture as well. Gas has suffered from oversupply for much of the past several years, casting a bearish pall over this market. High inventories and low prices have resulted in US rig counts falling by 94% from 2008-2016 – resulting in lower US production. It finally may be having an effect on supply. US inventories have fallen below the 5 year average for the first time in 17 months. China, for their part, is helping to spur demand on the global front. Chinese natural gas consumption is surging upwards as pollution controls finally begin taking place in that country. Natural gas consumption from January – November 2016 is up 15% over the same period in 2015.
To help meet this growing global demand, the US has just started exporting liquid natural gas (LNG) for the first time ever. This could have a substantial impact on supply in the years ahead.
Conclusion and Strategy
With longer term fundamentals beginning to take on a more bullish tone in the natural gas market, the month of March often ushers in one of the strongest times of year for prices. As natural gas inventories often hit a low in late March or early April, prices have historically begun to anticipate this supply drawdown as early as February.
As an option seller, however, you have no interest in trying to predict when or where any such price rally will begin – or even if it occurs at all. It is most often enough to know that historically, prices have tended to strengthen into Spring and that current supply figures (that drive those price moves) appear to be right in line with seasonal averages.
Thus, a put selling strategy would appear to be a high percentage approach for taking cash out of the natural gas market as February draws to a close. The recent drop in prices has fattened yields nicely on deep out of the money put strikes.
We’ll be positioning our managed accounts in the natural gas market across a variety of strikes and strategies in the coming weeks.
Non-clients can consider selling the August Natural Gas 2.50 put for premiums in the $500 range (current margin requirement is approximately $1,140.)
August 2017 Natural Gas
August 2017 Natural Gas chart showing the 2.50 strike price
The 2.50 strike price puts your position nearly 26% below the current price of Natural Gas. This means you don’t have to pick the time and place of a price low – but will still be in position to profit if and when prices strengthen in the next 4-12 weeks. More importantly, even if prices don’t see a seasonal price rally this year, your position can still profit – barring a particularly rapid descent in prices over the next 60-90 days – a scenario we view as increasingly unlikely.
Using a high odds approach such as selling options can help bring consistency to any portfolio. Combining it with a program that is attuned to the natural ebb and flow of supply and demand can be both intelligent and powerful.
For more information on managed option selling portfolios with James Cordier and OptionSellers.com, visit www.OptionSellers.com/Discovery. (Recommended initial allocation US $1 MM)
James Cordier is founder and head trader of OptionSellers.com, a US based wealth management firm specializing exclusively in option writing portfolios for high net worth investors. His latest book, The Complete Guide to Option Selling 3rd Edition, is available in bookstores now.