Natural Gas: Disappointing for Bears and Bulls, Yet Sweet for Short Volatility Option Writers

by: Five Thousand Over Libor

I am guilty of speaking too soon ... not the first, and unfortunately won’t be the last. Last year’s sizeable price decline for natural gas began about a month from now – I should have been more careful in assessing the likelihood of another decline in price signaled by the return to a contango front-spread given that it was the middle of January.

Quite simply, the aberrant weather parade detailed here in past articles appears to have no end in sight. If weather forecasts for the next two gas weeks (Jan. 27 and Feb. 3) materialize as forecasted overnight, La Nina for North America in winter 2010/2011 will go down as an epic failure.

The bear trade this winter didn’t necessitate La Nina, in fact winter weather anywhere between normal and moderately colder-than-normal would have driven a record high winter-ending storage level. Bears didn’t need it to be warm, just not 2-sigma cold.

Current forecasts drive a forecast from our storage models of a record January storage pull, around 850-870 Bcf. This would put the Dec.-Jan. storage draw at 1.51ish Tcf, also a record. Why? Because at forecast January looks to be the coldest for the U.S. since Jan 1985. And given the December 2010 we put in, with Florida enjoying its coldest December since records began 116 years ago (no one burns more gas per sq mile than Florida), and the southeast U.S. recording its third coldest December ever, it's becoming quite clear that Mom Nature wants to save this gas market one ... more ... time.

But the bulls shouldn’t exactly be ripping shooters in celebration. February gas trades $4.75 – right where it was in mid August (admittedly up a handsome 21% from its October low). This is still over a dollar lower than last year’s settle for today of $5.82. And the summer strip (April-October) trades $4.80, also a dollar lower than the trade one year ago today. All the manifestation of what now appears to be a forecasted record Dec. 1 – Jan. 31 storage draw. Calendar 2013 still trades inside 10 cents of its all time low – from October. In fact, since that low, that Cal 13 strip has had a 30-cent range ... it’s been about 10 cents since Dec. 1. Three years ago, gas would be booking several 50-plus cent days on these developments, and we’d be light-years beyond $5.00. Today, we have a pancaked forward curve (you still don’t find a $6 gas price in the calendar strips until 2017) which spells a great deal of trouble for those seeking additional large gains in the front from here. If calendar 2012 is trading $5.10 ... what can the front do?

I do expect the improved technical picture in the prompt contract to garner good levels of outside interest, but if the market won’t get its boot off the throat of the back of the curve, this renewed interest in gas will likely end as they have so often in the past, with distinct disappointment.

So weather once again drives astounding levels of NG demand that almost clears a remarkably oversupplied market. And gas remains pretty close to dead. A trade to $5 MAR gas appears far more likely than it did just a week ago, but anything establishing above there appears remote. I expect an April contract that trades near $4.15 by expiry late March. This is of course assuming we don’t stage record February and March draws to boot.

Furthermore, this elevated price level is of no help for the longer-term bulls, as a $4.80 summer trade, versus last year’s $4.17 summer average expiry, certainly isn’t as discouraging to supply as a $3.80 summer trade would have been, absent the perpetual presence of 2-sigma weather.

Natural gas: Disappointing for the bears, disappointing for the bulls, and nothing but sweet honey for the short-volatility option writers. All because weather can’t stop being absolutely insane. What a dynamic.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.