Gas Pains

The natural gas market is suffering from an embarrassment of riches. Everywhere you look, everyone’s got gas, and plenty of it. Production has increased, storage tanks are bulging (US gas storage is 13% higher than last year), and with a warmer-than-usual North American winter winding to a close, supplies could reach a record high.

As the global gas supply glut overhangs the market, forcing prices to rock bottom, smaller Canadian natural gas producers are feeling the pain. Not surprisingly earnings expectations are being revised downward following a year of stellar gains.

Share prices of mid-level Canadian natural gas producers have already sold off in the opening weeks of the year. Examples include Celtic Exploration Ltd. (TSX: CLT, Friday’s close $19.04), Paramount Resources Corp. (TSX: POU, $37.41), and Progress Energy Resources Corp. (TSX: PRQ, $10.89) which are down sharply from last fall. Growth targets will likely be revised downwards and cash flow will be squeezed because of an orgy of spending last year.

The question is whether the pound of flesh that the market has already taken from these companies is enough to discount the bad news. Or more importantly, have these companies overshot to the downside.

The challenge in this market is trying to develop a supply demand model when so many cross currents are at play all the time. Not the least of which is uncertainty around oil prices and the fact that no one can accurately predict weather patterns.

Considering the high cost of options in this sector – implied volatilities are in the top quartile of all Canadian companies – you have to think that the best approach is a hedged approach. In my mind, covered calls make the most sense.

For example, buying CLT at $19 or better while writing the July 19 Calls at $1.85 (implied volatility 27.03%) yields a six month return if exercised of 9.74%, which is also the return one would get if CLT remained unchanged. The downside breakeven is $17.15.

For POU, buy the shares at $37.41 and write the March 38 calls at $2.10 (IV 35.91%). The two month return if exercised is 7.19%. The return if unchanged is 5.61% and the downside breakeven is $35.31.

Finally, using PRQ, buy the shares at $10.89 and write the April 11 calls (IV 35.72%) at 50 cents. The three month return if exercised is 5.60%. The return if unchanged is 4.59% and the downside breakeven is $10.39.