Positioning for Major Reversal in Natural Gas Prices

Natural gas prices have continued to come under pressure and reach new lows, while crude oil has sharply rebounded from its lows. The North American natural gas market is almost entirely produced within North America, and recent industrial cuts due to the economic recession has caused severe demand destruction. However, unlike many other industrial focused industries, such as coal, steel, and other metals, supply cuts have not been profound among the natural gas producers.

It seems that those cuts may be coming this summer that could cause a very big spike in prices, due to the elasticity of natural gas prices, and large institutional option traders have been positioning for major gains among the companies heavily tied to natural gas.

Many of the natural gas related names have already begun to move higher as investors put money to work in the names ahead of the anticipated pricing rebound. The markets are generally forward looking and the stock price action is one indicator that natural gas is prepping for a recovery.

I follow the options market every day and I have always been very good at noticing trends, so when I began to see very risky, although with high reward, strategies being taken in the options market for many of the natural gas stocks, it sparked my interest.

One of the first trades was in XTO Energy (XTO) on Thursday, which is one of the most volatile stocks tied to natural gas prices due to the lack of hedging. The trade was a 5,000 contract risk reversal trade, with a trader selling 5,000 November $30 puts to finance part of the purchase of 5,000 November $40 calls in XTO. This is a very large monetary bet that could also lead to huge losses for this trader if XTO were to fall below $30, but this also shows the amount of confidence in the stock moving higher in coming months. This same trade was later duplicated at the May $28 strike for 2,500 contracts.

On Friday, Sunoco (SUN) and Murphy's Oil (MUR) also both had very large blocks of call options being bought at the offer for the May strikes, looking for a sharp move higher that is coming soon.

Many of these companies will report earnings this week and I expect to hear some bullish comments from the CEOs as to where prices are heading. The valuation on many of these companies is at historic lows, leaving a lot of room for upside moves in share prices. Many of the names have also been popping on my radar as nearing technical breakouts as well.

If you want to own stocks with cheap valuation, bullish technical signals, and large amounts of money being bet by the "smart" money, natural gas stocks are the place to be for the summer.

Some other names to invest in include Apache (APA), Devon (DVN), Penn Virginia (PVA), Denbury (DNR), Chesapeake (CHK), Anadarko (APC), Ultra Petro (UPL), Williams (WMB), Range Resources (RRC), SouthWestern Energy (SWN) and EOG Resources (EOG).

Risk Reversal trades can be a very lucrative way to play these names, selling puts at strikes near lows/support on the stocks, and using the money to purchase out of the money calls. It is a great way to lessen the cost for the calls and making a stand that shares have seen lows, and things are not going to worsen anytime soon.

Disclosure: I own XTO and am considering ownership in SWN, MUR and UPL

Comments

[pelicansand...:]

No mention of LNG imports coming online? I think this has to be part of the discussion for any possible gas price rebound...

May 04 08:48 AM

[calvino:]

Thanks for the heads up on the options trades!

May 04 08:52 AM

[really:]

Since when is Denbury a natural gas company? It primarily produces oil.

May 04 09:25 AM

[Spicer:]

Sunoco is an oil refiner, it doesn't produce crude oil or natural gas.

May 04 09:42 AM

[Swing Meyer:]

What about CHK, the largest natural gas supplier in US?

May 04 12:08 PM

[Steve Ward:]

NG doesn't catch a break existing wells are shut in.
New drilling already has slowed down but it will take more. Some possible boosts to NG pricing could be a carbon credit scheme and the rising opposition to water pollution from shale gas production. Long term.it will take more of a sea change in the gas supply. Anything else isonly a temporary blip up.

May 04 01:57 PM

[Eric Fox:]

Denbury has properties in the Barnett Shale that produce gas, and just for the record - the entire concept of "smart money" died during the financial crisis.

May 04 11:37 PM

[thotdoc:]

They may not be "smart", but they still throw around a lot of weight.


On May 04 11:37 PM Eric Fox wrote:

> Denbury has properties in the Barnett Shale that produce gas, and
> just for the record - the entire concept of "smart money" died during
> the financial crisis.

May 05 09:27 AM

[Archaean:]

The production cuts were a response to decrease in demand, they did not cause demand destruction. The '08 spike in oil prices sparked a slowdown in economic activity. There's a lot more natural gas in the US than was previously projected, given the recent advances in production and wins in exploration, a la shale finds.

May 05 03:32 PM

[PutneyHillYank:]

I tutally agreeith this articlet and yesterday adding CHK for obvious reasons ie the 12 percent decline yesterday was dumb and continue to hold add TLM


On May 04 04:28 AM Freya wrote:

> The Jury has yet to vote. But if you are right, and I expect you
> are, I vote for CQP. I am biased.

May 06 07:19 AM

[Focus Advisory:]

The move up from the low of $3.20 is a head fake. The market is greatly over supplied, LNG is set to double this year, and industrial demand should weaken further with multiple auto plants going idle this summer.
I don't think gas goes below $3, but gas will pull back again to test the low. Price is not a catalyst to buy. The catalyst will come late summer early fall when prices are low and investors are betting on a recovery in 2010 and its coming winter weather.
Natgas stocks are WAY ahead of themeselves. If they don't come back as gas does, I'll play the rebound with UNG.

Regards

May 06 04:28 PM

[Eric Fox:]

The worst reason I can think of to buy a stock is because someone else is buying it.


On May 05 09:27 AM thotdoc wrote:

> They may not be "smart", but they still throw around a lot of weight.
>

May 13 11:11 AM

[Joe Kunkle:]

Well you are missing out on a lot of huge gains then, XTO surged around 20% in a few days after my write up....and the strategy has worked for well over 100% gains this year in an all options portfolio


On May 13 11:11 AM Eric Fox wrote:

> The worst reason I can think of to buy a stock is because someone
> else is buying it.

May 13 03:51 PM

[Eric Fox:]

Joe...my comment was not a criticism of you or your investment process. I am in favor of investors doing as much independent research as they can before making an investment.

May 15 07:04 AM

[TraderMark:]

Well timed article in retrospect!

May 20 09:58 AM

[Mistrofan:]

Completely disagree! During this summer, NG and NG related stocks should do probably the WORST from the commodities group. Your scenario is good but for OCTOBER - not for this summer.

May 20 12:04 PM

[sgtrock:]

Not all natural gas companies are the same. CHK is a resource play company. Resource plays (shale gas) are a low risk, but very low margin gas business. There is low risk in getting gas from the well, but it takes hundreds of wells to equal the daily gas production from a convention gas field. The exploration risk on a conventional gas play is higher, but the margins and NPV are usually significally higher than resource plays.

CHK greatest return on their investment has come from selling equity a working interest in two different resource plays to Super Majors, who were in need of a "story" to tell analysts.

Jun 26 01:06 AM

[Freya:]

Steve: NG's decline has leveled off, do not expect a move to retest the lows, like you said, existing wells are getting shut in.

Pelican: CQP is an LNG Royalty Trust.

The Bespoke group's latest charts are generally commodity favorable.

May 04 03:35 PM

[Freya:]

The Jury has yet to vote. But if you are right, and I expect you are, I vote for CQP. I am biased.

May 04 04:28 AM