With all of the macro-economic noise in the markets right now, it may seem counterintuitive to focus on something as “old school” and mundane as seasonal tendencies. And yet, despite GDP reports, Buffet buyouts and Chinese manufacturing, the annual, everyday supply/demand cycles of the physical commodities can often hold a much stronger influence on overall price direction than any other factor.
While agricultural commodities are often affected by planting and harvest (supply) cycles, there is no market more influenced by demand cycles than the energy markets.
As we have oft noted in past commentaries, unleaded gasoline demand spikes during the US summer months when weather is mild, kids are out of school and travel is favorable. But what happens after “driving season?”
There is a sharp drop in retail gasoline demand in September. This drop in demand can often cause a price slide in the wholesale gasoline market. At the same time, refineries begin switching over to heating oil production in late summer in order to have enough inventory on hand to meet winter needs. Therefore, gasoline production takes a back seat and wholesalers allow inventories to be sold off – drawing down stocks.
It is not uncommon during the autumn months to see gasoline prices declining – even though stocks are often declining at the same time. The drop in demand tends to trump all.
The interesting fact about 2009 is that while autumn arrived and demand dropped off as usual, inventories have not yet experienced the expected seasonal drawdown – at least to the magnitude which is typical. In fact, inventories remain more than 5% above seasonal norms and 7% higher than 2008 levels. One would think that this drop in demand while supplies remain high would lead to a more pronounced decline in prices. It has not.
The question is, why?
Macro-economic headlines supporting Markets
There are occasionally times where markets temporarily disconnect from pricing existing fundamentals and go off in their own direction. Like a teenager in love, they can stray wildly, allowing emotion, not reason to temporarily lead them.
Energy markets are currently being supported by a stimulus created (and media supported) “recovery” euphoria. At the very least, they are being supported by an expectation of global economic recovery. In short, the market is pricing in demand that is simply not there yet.
These expectations, spurred on by a weaker dollar and higher equities market, has resulted in speculative money pouring into the energy markets. The October 27th commitment of traders report with options showed spec and fund net long positions hit an all time record high of 181,672 contracts as of early last week. Unleaded (RBOB) gasoline longs are within 5% of the all time highs attained in May of 2008. This means momentum following fund managers and John Q. Public are betting on higher prices. Commercial traders, of course, are heavily short and adding to short positions across the petroleum sector.
Technical traders refer to this kind of set up as “overbought.”
In short, our view of the energy markets at this time is one of overstocked inventories, seasonally weak demand and a technically overextended market ripe with speculators.
To be sure, it’s a set up for a stout correction. But like the teenager, nobody knows when he’s coming home. He should, he could, he usually does, but if the allure of the spell is strong enough, he might not.
Energy prices are no different. Crude, heating oil and unleaded gas rallies have run into some recent headwinds. This could be the beginning of a fundamentally based retracement. Then again, speculative led strength cannot be discounted in the short term.
Public Interest = Private Opportunities
The spec interest in the energy markets comprises a large percentage of individual traders (the public) whose preference is to buy options – specifically, buy call options. This demand for calls inflates premiums, even at strikes that are highly unlikely to ever be attained. While this is true across the energy sector, we focus on unleaded gasoline (RBOB) here because it has the added potential for seasonal price pressure. For instance, calls are currently available in unleaded gasoline that are more than 100% out of the money. In other words the strikes are at levels more than double the current value of unleaded gasoline on the NYMEX.
This is why we sell options and why you may want to consider employing the strategy. Sell options this far out of the money and collect the premiums. As long as unleaded gasoline prices do not double prior to expiration, the option will expire worthless and the seller keeps the premiums. In other words, prices can experience a deep correction, consolidate sideways or even push moderately higher. Only an explosive move to the upside can force the deep out of the money call seller’s hand.
Energy prices may still have some spec momentum to the upside. However, the fundamental weight now pressing on the market should, at the very least, keep things from going too far. Selling deep out of the money calls could be the most consistent method of capitalizing on an expected correction – even if it never comes.
To learn more about selling options in the commodities markets, feel free to visit us on the web at www.OptionSellers.com. A complimentary option selling information pack is available for qualified investors.
