Buying Natural Gas Put Options to Profit from a Fall in Natural Gas Prices

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Why Are Gas Prices So High?

When Else Have Prices Been as High

Image by Theresa Chiechi © The Balance 2020

For the week of April 29, 2020, the U.S. regular gas price was $2.76 a gallon according to the Energy Information Administration. That’s a 30% increase over the $2.12 a gallon listed for the week of January 7, 2020. That’s lower than the $2.85 a gallon for prices last year. Gas prices typically rise in anticipation of higher demand in the summer driving season.

High gas prices are created by high crude oil prices. Oil costs account for 54% of the price of regular gasoline. The remaining 46% comes from distribution and marketing, refining, and taxes, which are more stable. When oil prices rise, you can expect to see the price of gas to eventually rise at the pump.

Three Causes of High Gas Prices

The three major causes of high gas prices are supply and demand, commodities traders, and the value of the dollar. These are also the determinants of oil prices.

Supply and Demand. Like most of the things you buy, supply and demand affect both gas and oil prices. When demand is greater than supply, prices rise. For example, U.S. shale oil producers increased the oil supply in 2020. Gas prices fell to their lowest levels in five years. But that shale oil boom reversed when low prices put many producers out of business.

Seasonal demand also affects oil and gas prices. You can expect them to rise every spring. Oil futures traders know the demand for gas rises in the summer as families go on vacation and hit the road. Regulations also require a shift to summer-grade gasoline, which is more expensive to produce. They start buying oil futures contracts in the spring in anticipation of that price rise.

Commodities Traders. Traders of commodities like gasoline, wheat, and gold, also cause high gas prices. They buy oil and gasoline at the commodities futures markets. Those markets allow companies to buy contracts of gasoline for future delivery at an agreed-upon price. But most traders have no intention of taking ownership. Instead, they plan to sell the contract for a profit.

Since 2008, both gas and oil prices are affected more by the ups and downs in these futures contracts. The price depends on what buyers think the price of gas or oil will be in the future. When traders think gas or oil prices will be high, they bid them up even higher. In this way, commodities traders create a self-fulfilling prophecy. This leads to an asset bubble. Unfortunately, the one who pays for this bubble is you at the gas pump.

The Value of the Dollar Declines. Gas and oil prices also rise when the value of the dollar declines. Oil contracts are all denominated in dollars. Oil prices rose between 2002 and early 2020 because the dollar lost 40% of its value during that time. Oil prices fell between late 2020 and 2020 in part because a strong dollar allowed the members of the Organization of the Petroleum Exporting Countries to make more money while keeping supply constant.

When Else Prices Have Been High

Here’s how different situations, from conflict on the world stage to engineering mishaps, affected the price of gasoline.

April 2020: Fears about unrest in Libya and Egypt sent oil prices up to $113 a barrel. In May 2020, as oil prices dropped, the price at the pump stayed high. Why? Commodities traders were concerned about refinery closures due to the Mississippi River floods.

February 2020: Concerns about a potential military action against Iran, by either Israel or even the United States, caused high oil prices. Second, some U.S. oil refineries were closing, according to an Environmental Impact Assessment report. Third, oil and gas prices tend to rise every spring, in anticipation of increased demand during the summer.

As a result, the prices for a gallon of gasoline hit the benchmark $3.50 by February 15, two weeks earlier than in 2020. By mid-March, the national average had jumped to $3.87 a gallon. That’s because, two weeks earlier as well, the price of oil reached its benchmark of $100 a barrel. Oil went on to hit $109.77 per barrel by the end of February, before dropping slightly to $107.40 per barrel in mid-March.

August 2020: Prices were high as a result of Hurricane Isaac, which hit the U.S. Gulf Coast region on August 28, 2020. In anticipation of the Category 1 hurricane, refineries in the area shut down production. As a result, crude oil production lost 1.3 million barrels per day. This caused the average national price of gas to jump in one day, from $3.05 per gallon to $3.80 per gallon. Prices in Ohio, Indiana, and Illinois rose even further, as the storm closed a pipeline that feeds the Midwest.

September 2020: Prices rose to an average high of $4.50 a gallon in California. That was because of a supply shortage from two causes. The first was a power outage at the ExxonMobil refinery in Torrance, California. A heat wave caused the power failure. The second was a shutdown of a major north-south oil pipeline. These came on top of East Coast refinery shutdowns due to regular seasonal maintenance.

March 2020: Iran started war games near the Strait of Hormuz early in 2020. Almost 20% of the world’s oil flows through this narrow checkpoint bordering Iran and Oman. If Iran threatened to close the Strait, it would have raised the fear of a dramatic decline in oil supply. In anticipation of such a crisis, oil traders bid up the price, which reached $118.90 a barrel on February 8. Gas prices soon followed, rising to $3.85 a gallon by February 25. These rose again in August 2020 because oil prices hit a 15-month high that summer. That spike was created by political unrest in Egypt.

April 2020: Prices rose in April 2020 because the price for domestic oil rose to $101 a barrel. The domestic oil price is benchmarked by the reference grade, West Texas Intermediate. Oil prices rose because new pipelines from the Cushing, Oklahoma storage hub lowered inventories to the lowest level since November 2009. In addition, the price of imported oil, a grade called the North Sea Brent, rose to $110 per barrel. This was caused by political unrest in Ukraine, Nigeria, and Iraq. The EIA expected average national prices of gasoline to remain at $3.60 a gallon until May.

July 2020: In California, the price at the pump increased to almost $4 a gallon in July 2020. Midwest refinery problems sent California’s oil elsewhere. Since it doesn’t have major pipelines from other regions, California had to wait for tankers with imported oil to arrive. A similar issue happened in 2020. It was just a temporary regional problem.

August 2020: Gas prices rose from an average of $2.58 a gallon to $2.62 a gallon. This spike was due to an outage at BP’s Whiting refinery in Indiana, making prices in the Midwest higher than average.

November 2020: Gas prices rose when OPEC cut production. Members agreed to reduce supply by 1.2 million barrels per day in January 2020. In response, traders bid oil prices to $51 a barrel in December 2020. That was double the 13-year low of $26.55 a barrel in January 2020. Gas prices rose for 14 consecutive days after the meeting. The national average of $2.21 per gallon was up 20 cents compared to the same time period the previous year.

August 2020: Average gas prices rose from $2.35 a gallon to $2.49 a gallon. Hurricane Harvey wiped out 5% of the nation’s oil and gas production. The Department of Energy released 500,000 barrels of oil from the Strategic Petroleum Reserve. By September 5, gas prices had returned to normal.

November 2020: OPEC agreed to keep production cuts through 2020. At a meeting of OPEC and non-OPEC oil-producing nations in December of 2020, they again cut production. On January 15, 2020, the EIA released its forecast for two major crude oil benchmarks, Brent and WTI. The agency predicts that Brent will average $60.52 per barrel in 2020 and $64.76 in 2020, while the WTI will average $54.19 and $60.76.

May 2020: Global oil prices reached $80 per barrel following the U.S. decision to pull out of the Iran nuclear agreement and reinstate sanctions. Production in Iran dropped through the end of 2020. In addition, Libya and Venezuela faced limited production. Gas prices rose to $2.85 a gallon.

Factors That Force High Gas Prices to Drop

The April to September vacation-driving season often causes an increase in gas prices. But prices fall in the winter since transportation needs and production costs are lower. This price decrease even offsets an increase in home heating oil usage for winter in northern areas of the United States.

Gas prices will drop when supply increases. There are a lot of ways that could happen. OPEC could decide to release more oil. The United States could lift sanctions against Iran. Shale oil producers could find another large deposit or create new technology.

Prices will also fall as the dollar’s value rises. OPEC can allow supply to expand since they’ll remain profitable with a rising dollar.

Most important is the impact all these factors have on commodities traders. If they believe oil and gas prices will fall, they won’t bid up futures contracts. They may even find another investment, allowing prices to decline further.

What We Can Do to Reduce Prices

The most immediate thing we can do is reduce our usage of gas by driving less or increasing fuel efficiency. The best way to increase fuel efficiency is to keep tires inflated. Urban dwellers can use public transit. Others can move closer to work to reduce commuting time.

For the long term, we can change our need for oil and gas by switching to alternative fuel vehicles.

Could these actions reduce the high price of gas? They might if they were on a sustained basis over a long period of time.

The only real way for consumers to lower gas prices is to reduce demand for gas and oil for a sustained period. But the demand for gasoline and fuel isn’t declining, and it’s unclear whether the development of alternative fuels will help. The United States consumes 20% of the world’s oil. This has increased over the last 20 years, from 15 million barrels per day to 19.69 million barrels per day. It’s expected to keep rising, at least over the short term.

Is 2020 The Year To Invest In Natural Gas? – Here’s How With CFDs

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Last Updated on August 15, 2020

3 Reasons You Might Invest in Natural Gas

Historically, natural gas has been a regional business. The low density of the fuel makes putting it in cargo ships and transporting it overseas an impractical endeavor. (LNG solves the problem of density, but LNG adoption has been limited due to the high cost of cryogenic equipment and other LNG infrastructure.)

However, recent developments such as compressed natural gas (CNG) could soon change the economics of the business and make trade in natural gas more practical.

Still, regional economic, political and regulatory factors matter to natural gas prices more so than to many other commodities. With that in mind, traders should consider buying natural gas for the following reasons:

  1. Clean Fossil Fuel Demand
  2. Inflation and Weak US Dollar Hedge
  3. Portfolio Diversification

Bet on Clean Fossil Fuel Demand

Natural gas is considered a much more environmentally-friendly fuel than petroleum or coal. It burns cleaner and produces fewer carbon emissions.

In addition, natural gas is lighter than air. In the case of a leak, it will dissipate, which gives it a safety advantage over gasoline.

Global Carbon Emission Comparison via Mak Thorpe on Wikipedia

How is Natural Gas an Inflation and Weak US Dollar Hedge?

Investing in natural gas is a way to bet on a weak US dollar and higher inflation.

Natural gas is priced in US dollars, so the performance of the world’s largest economy can impact its price. The US Federal Reserve Bank has kept interest rates low and the US dollar weak for many years.

A weak dollar could stoke inflation concerns. Since there is a limited supply of natural gas, the price of the commodity could benefit from fears of inflation.

Diversify Your Portfolio

Investing in natural gas along with other commodities is a way to diversify an investment portfolio.

Investors seeking true asset class diversification should consider putting a portion of their investable assets into a basket of commodities including natural gas, other energy commodities, metals and agriculture.

Should I Invest in Natural Gas?

Natural gas prices can be volatile, and traders should expect large price swings.

However, investing in natural gas can be part of a sensible plan to mitigate risk and diversify the composition of assets in a portfolio.

Investing in a basket of commodities that includes natural gas, other energy commodities such as gasoline and crude oil, agricultural commodities and metals can protect against inflation. It can also protect a trader from the volatility of movements in individual commodities.

There are three specific trends that could boost natural gas prices in the years ahead:

  1. Global Demand
  2. Environmental Concerns
  3. Regulation

Global Demand

Developments in CNG have the potential to make natural gas more of an international commodity. As transportation of natural gas becomes more affordable and practical, demand for the commodity could surge.

Environmental Concerns

Some fossil fuels such as coal are receiving intense scrutiny because of the pollution they create. These concerns make greener energy sources such as natural gas more attractive.

Regulation

Fossil fuels such as coal and crude oil produce harmful and toxic carbon emissions. China is regulating the production of these dirty fuels and replacing coal-fired plants with natural gas and wind.

Wind Power China via Wikimedia

However, traders should also consider the risks of investing in natural gas:

  1. A global recession could weaken energy demand.
  2. Higher natural gas prices or lower costs for even greener sources of energy could lead consumers to substitute consumption.
  3. Global economic or political turmoil could strengthen the US dollar and weaken demand for commodities.

What Do the Experts Think About Natural Gas?

Many energy companies see natural gas as a key driver of their future growth. A CEO of one of the world’s largest energy companies sees the energy as the fossil fuel of the future :

“Natural Gas is flexible enough to offer the right combination with renewables…we are positioning Total more and more in gas, and in 35 years Total will distribute more oil than gas.”

Patrick Pouyanne, CEO of Total SA

The largest oil and gas company in the United States and fifth largest in the world agrees with this assessment:

“Natural gas is a major game changer with fewer emissions, flexibility and abundance.”

However, analysts have mixed opinions about natural gas.

One leading analyst believes that increased US production of natural gas from shale and declining demand will produce lower prices in the future:

“Natural-gas prices are very low and have been for a while. It’s also a by-product of the shale revolution in the U.S. Natural gas is what powers most of our electricity needs, right? And that combined with renewables is another important trend that will affect energy prices globally. So we also have a negative long-term view.”

Dan Chung, Fred Alger Management

How Can I Invest in Natural Gas?

Investors have several ways to invest in natural gas:

Method of Investing Complexity Rating (1 = easy, 5=hard) Storage Costs? Security Costs? Expiration Dates? Management Costs? Leverage? Regulated Exchange?
Natural Gas Futures 5 N N Y N Y Y
Natural Gas Options 5 N N Y N Y Y
Natural Gas ETFs 2 N N N Y N Y
Natural Gas Shares 2 N N N N Y Y
Natural Gas CFDs 3 N N N N Y Y

Natural Gas Futures

The Chicago Mercantile Exchange (CME) offers a contract on natural gas futures. The contract is based on delivery at the Henry Hub in Louisiana, a location where multiple interstate and intrastate pipelines converge. The contract settles into 10,000 million British thermal units (mmBtu) of natural gas.

The contract trades globally on the CME Globex electronic trading platform and has a variety of expiration months.

Futures are a derivative instrument through which traders make leveraged bets on commodity prices. If prices decline, traders must deposit additional margin in order to maintain their positions. At expiration, the contracts are physically settled by delivery of natural gas.

Investing in futures requires a high level of sophistication since factors such as storage costs and interest rates affect pricing.

Natural Gas Options on Futures

The CME offers an options contract on natural gas futures.

Options are also a derivative instrument that employ leverage to invest in commodities. As with futures, options have an expiration date. However, options also have a strike price, which is the price above which the option finishes in the money.

Options buyers pay a price known as a premium to purchase contracts. An options bet succeeds only if the price of natural gas futures rises above the strike price by an amount greater than the premium paid for the contract. Therefore, options traders must be right about the size and timing of the move in natural gas futures to profit from their trades.

Natural Gas ETFs

These financial instruments trade as shares on exchanges in the same way that stocks do.

There are several ETFs that invest in natural gas including some that make leveraged bets on the commodity. However, traders should be wary of leveraged ETFs since they reset each day. This makes them only effective as day-trading instruments. The most popular non-levered natural gas ETFs include United States Natural Gas Fund and First Trust ISE-Revere Natural Gas Index Fund.

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