Natural Gas Market Is Substantially Oversupplied

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Includes: UNG
by: Ananthan Thangavel

The following chart shows the price of natural gas in amber, Managed Money net shorts in white, and Producer net shorts in green.

[Click to enlarge]

As can be seen, Managed Money has aggressively covered their shorts over the past few weeks, leading to the lowest net short position among Managed Money since 2007. With seemingly very little change in natural gas fundamentals, this huge move seems curious.

In our estimation, the recent short covering appears to be motivated by simple trading activity rather than any change in underlying fundamentals. What we mean by this is that traders frequently monitor how short or long the market is on a particular security, and then push the market in the direction against the current trading position.

In this example, as natural gas prices rose, short sellers were forced to cover in greater and greater numbers, causing a price appreciation (aka a short-squeeze). However, we believe that the recent short covering is nothing more than a temporary price reaction due to the incredible willingness of Producers to sell at these prices.

The green line shows that Producer net short positions are at their highest level ever. This means that Producers are the most willing to hedge their production at current prices than they ever have been. Given that natural gas is only around $4.70 per mmbtu, this willingness to lock in current prices seems strange.

However, the degree to which the natural gas market is oversupplied is substantial, and Producers’ willingness to hedge reflects natural gas’ low price ceiling. We believe the Producers’ willingness to sell limits any advance in natural gas prices, and selling calls remains an attractive position.

Trade Recommendation

We recommend selling the August 5.2 calls for .095, or $950 per contract. Such a position would be profitable as long as natural gas is below 5.2 at the end of July. Natural gas could advance by almost 10% in that time span and the investor would still collect 100% of the premium on these options.

If you sold the 4.65 calls we recommended previously, we would recommend taking a smaller position in these calls, as you already have significant short exposure to natural gas. However, selling these calls will also average you in to the short trade as well, so that you can take advantage of these higher prices.

Disclosure: Author is short natural gas calls.

Disclaimer: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.