Recent activity in energy markets has obviously been influenced heavily by unrest in the Middle East and North Africa. For the year, West Texas Intermediate crude oil is up 20.75%, while the more internationally-influenced Brent Crude is up an astounding 33.36%.
However, in the same period Henry Hub natural gas is down 8.86%. One futures contract worth of natural gas (1 mmbtu) should have about one-fifth the energy content of one contract worth of crude oil (1,000 barrels). It follows that in a normally functioning, perfectly efficient energy market, crude oil should be about five times more expensive than natural gas. However, with natural gas at 4.04 and WTI crude at 112.79, this ratio currently stands at an incredible 27 times.
In the past, we have discussed the extremity of such a ratio as being a catalyst for either a fall in crude oil prices, a rise in natural gas prices, or both. Unfortunately for natural gas, such is not the case today.
The following chart shows natural gas managed money net shorts against the price of natural gas.
Since 3/1/11, managed money net shorts have decreased 53%. However, in the same period, the price of natural gas has increased by only 0.5%. To put this in perspective, this means that approximately 111,000 contracts of natural gas have been bought back by short sellers, but even that gargantuan amount of short-covering has only produced a 0.5% rise in the price of this commodity. Such a low price increase with such dramatic purchasing by managed money indicates that there must be another factor at play: producer selling.
The following chart shows the same elements as above, but overlayed with natural gas producer net shorts in green.
As can be seen, producer shorts have hit an all-time high (as producer chart is below zero, a further increase in short positions shows the line on the chart heading downwards). Practically, what this means is that Producers of natural gas [i.e. the Chesapeake Energy (CHK) and Exxon Mobils (XOM) of the world], are hedging their natural gas production at the fastest rate ever. The natural gas producers are incredibly eager to lock in prices between the 4-4.5 level. While this seems downright insane considering that natural gas was above 10 just 3 years ago, the amount of new natural gas production coming online each day is huge.
The fact that prices are already at $4 with natural gas managed money shorts hovering around 2-year lows means that renewed managed money selling could drive prices significantly lower than where they are today. Cheap domestic natural gas drilling has made some Producers profitable down to prices of even $3 per mmbtu or even lower in some cases, so these Producers will keep drilling even if prices continue to head south. Rather than shut down production and wait for better prices, natural gas producers are ramping up production and selling futures contracts heavily in order to lock in prices.
Trade Recommendation
The extreme willingness of producers to sell natural gas at these prices yields a very attractive risk/reward trade. We recommend selling calls above natural gas’ recent high of 4.48. Such a trade would entail selling the June 4.5 calls for .07, or $700, per contract. As long as natural gas closes below 4.5 on May 28 (9.6% higher than where it currently trades), the investor keeps all $700 per contract.
In order to effect the same trade using the UNG, investors could sell the May 12 calls for 0.13.
These trades carry the risk of selling uncovered calls. In the event of a large, unexpected rally in natural gas, investors could be left short natural gas in the face of a large rally. However, we would view any rally in natural gas as being short-lived due to the likelihood that producers will utilize any rally to increase long-term hedges. With natural gas producers this willing to sell at prices between 4-4.5, a sustained rally past 4.5 is highly unlikely. Furthermore, managed money will most likely begin to realize Producers’ predicament and start to increase their short positions again. Such a development could cause severe downside for natural gas, and cause a retest of the 3.5 level seen in late October 2010.
More aggressive traders may wish to short natural gas futures outright, or buy put options on natural gas futures. An intriguing trade could be to short or buy puts on the UNG instead of futures due to UNG’s documented underperformance of natural gas futures. short nat gas calls long nat gas puts.
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