Natural gas prices reflect a degree of enthusiasm that is typical for this time of year, particularly if there are hurricanes lurking in the Gulf of Mexico, but according to one market observer, once traders weigh healthy storage inventories against expected winter weather, an option strategy designed to take advantage of high levels of volatility may be the trade to make.

“If you look at the way prices are tracking, it’s as if there were very tight inventories. The market is, therefore, anticipating that the inventory situation is going to tighten up significantly, or it’s setting itself up for a pretty nasty correction,” said Bill O’Grady, senior analyst with A.G. Edwards.

“That’s probably a four-to-six week situation, but once winter arrives, it’s a matter of how cold it gets. Solid cold weather will see the inventory go pretty fast, because it does appear that productive capacity has been impaired. If it doesn’t, prices will work lower.

“I think the market is optimistic [bullish] on the winter. It often happens this time of year. It’s a little bit like spring training. Even the Devil Rays have a shot at the pennant,” he mused. “Once the season starts, and once it gets into early November that’s when you see prices really fall. Right now the market is pretty rich.”

He noted that many people are scratching their heads right now because storage inventories are only 9 Bcf shy of 3 Tcf, which historically has been ample storage to handle normal winter demand.

O’Grady noted that the industrial sector of the economy is still struggling; it is in recovery but not expansion. “It has clearly bottomed, but not broken out of pre-recession highs,” he said. “Steel and chemicals are doing better than earlier, but capacity utilization numbers are running about 75 to 76 %, and when the economy is rocking and rolling, it’s more like 83%,” he said.

Given that kind of market, O’Grady sees a trading opportunity. Selling options has been the most effective, he said.

“Trading futures is great when you get it right, but losses can be deadly. There is so much volatility in this market that most of the time you can write options on either side and do pretty well. You won’t knock the cover off the ball. It’s a lot like a sporting event, if the pitcher is working the outside corner you take it to the opposite field, and if a defense is overplaying the pass, you run. That’s what the market is telling you. There is a lot of volatility here, and if you think the volatility isn’t going to get any worse, there are good opportunities to sell options.

“We’ve been looking at November options once the tropical storm activity gets out of the way,” he said. “You have to be careful, though, the premiums are high or low for a reason. It’s a probability game. You want to trade when there’s a lower risk threshold.” At some time, selling November calls should work, he added — something like $4.20 to $4.30 calls.

Other analysts are focusing on long term supplies. The lack of a significant drilling response by producers has some checking their spreadsheets.

“I think that what has happened this year is that the industry has retrenched,” says Kevin Petak, director at Arlington, VA-based consulting firm Energy and Environmental Analysis Inc. “The Enron debacle, and the difficulties with energy merchants has left firms cash flow constrained, and they are having difficulty getting capital. And their corporate management is focused on a lot of different problems other than growing the industry.

“You would think that exploration and production would be OK, but unfortunately there is a big segment of the E&P sector that is fully integrated,” he noted. “El Paso, for example, is the fifth largest producer in the United States, so any energy merchants with production are faced with the problem of raising capital. That’s part of the reason the rebound in drilling hasn’t been what we anticipated. The rig count has been creeping up since April, but it’s more of a crawl than a vibrant increase.

“This is setting the stage for some really high gas prices with any normal weather,” Petak said. “Everyone is expecting a warmer than normal winter, at least that’s what a number of forecasters are expecting, but I don’t put much stock in their forecasts. Weather forecasters make a number of energy analysts look good.”

Petak predicted the winter gas market would be very reliant on storage. “Once you start drawing storage down that will bring price pressure to the market,” he said. “Our forecast is constructed with normal winter weather. If there were cold weather, there would be really high gas prices, but with warm winter weather, prices are not apt to fall below $3.00 this winter. The risk is for higher prices.” (Republished with permission from Bill Burson, )

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