Warm Up With A Potential 170.3% Return

There’s a cold front moving across the U.S. right now, causing natural gas prices to rise. But that’s not even the most interesting story surrounding oil’s little sister.

With sustained lower prices over the last few years, natural gas production in this country has fallen. The boom we saw in the Bakken, Woodford and Barnett gas fields a few years ago has trailed off a bit. It’s just not as profitable of an enterprise as it was when prices were double what they are now four or five years ago.

This dip in production has spurred a gradual and unerring decline in the amount stored for the U.S.

The way natural gas works is each year there’s a period when underground storage stocks build up (spring and summer) followed by depletion (fall and winter). When both the peaks and valleys in the amount stored are declining, you know the price is affecting producers. That’s the case since 2015:


Remarkably, this hasn’t yet turned the tides for prices yet. Consumers are still using just as much as they were a few years ago. Winters haven’t somehow gotten any warmer. The current cold snap is proof that demand is still high. But this supply remains low.

That means to deal with it, this storage needs to be tapped more than ever. In the long term, that means production will eventually have to pick up to replace what is lost this winter. But there’s another way to play all of this, even if nothing changes in natural gas prices or production in the short term…

The Real Winner in a Natural Gas Shortage

Exxon Mobil is the largest natural gas producer in the US. A few years ago, it went on a buying spree to make sure of this fact. And while the company will likely be the beneficiary of higher demand — if only to replace the deplete underground stocks — it might not see any benefit just yet.

Instead, we should look at the companies that actually control the flow of natural gas… pipelines. The largest of these is Enterprise Products Partners (NYSE: EPD). It controls 50,000 miles of pipelines, 14 billion cubic feet of natural gas storage and 26 natural gas processing plants. It also is a major player in the still growing liquefied natural gas export business.

All of this means that when there’s a rip in supply and demand, and natural gas needs to be either stored or taken out of storage, EPD is the biggest winner. As you can see, despite lower natural gas prices, EPD has still done well over the last few years:

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With this cold snap now bringing natural gas back into focus, EPD could go back onto the minds many investors.

As you can see in the first chart, underground storage is about to hit the end-of-winter lows of 2016… and it’s only January! As either production picks up or storage is depleted faster, the company that transports that natural gas benefits.

This all comes just as EPD and its largest competitor, Kinder Morgan, are set to announce their 2018 year-end earnings. Kinder goes first next week, followed by Enterprise two or three weeks later.

This could easily be the catalyst to give these companies, but most specifically EPD, a breakout. Kinder is a solid company, but it has some debt leverage issues and is relying on a lot of new projects to attract investors. EPD is in a firmer position to take advantage of the current natural gas situation.

Analysts at these two companies know them well. These are both old Texas companies with a bit of an ole’ boys’ club following. Even these analysts, who we imagine smoke cigars and shoot guns with these pipeline execs are saying that this quarter is different. Revenues are expected to spike here. Investors have been waiting. If that happens, these stocks could rise significantly over the next month.

This gives us a tremendous short-term opportunity. EPD should see its stock rise. Yet, its rather steady track record has kept option premiums low, despite the volatility in the rest of the market. For us, that’s a great time to make a trade.

A Strategy For Short Term Natural Gas Bulls

A bull call spread is a type of trade that can return a profit on a slight rise in the underlying stock’s price, while limiting the amount at risk. Here’s how it works.

A trader looking to get into a bull call spread would first buy a call option on a stock he thinks is going to go up in price. He then sells a second call option on that same stock but with a higher strike price. The second call’s premium offsets the cost of the first call.


Source: The Options Industry Council

This results in a net debit, but far lower of a debit than a straight call purchase. True, the potential profit is capped at the upper strike price. But with lower-than-usual entry costs, bull call spreads often come with a great risk-reward profile.

Let’s look at a specific example.

A Specific Trade For EPD Bulls

To enter a bull call spread trade on EPD, a trader could buy February 15 $27 calls for $0.65 per share and sell February 15 $28 calls for $0.28 per share for a net debit of $0.37 per share or $37 per contract (each represents 100 shares).

That’s the total cost and total risk of this trade… $37.

To find the potential profit, take the difference in strike prices ($28 – $27 = $1) and subtract the entry cost ($1 – $0.37 = $0.63). Because each option is worth 100 shares, that’s a maximum profit potential of $63 per contract.

That $63 profit potential is a return of 170.3% of the amount at risk, $37. To collect this full maximum return, shares of EPD would only have to hit $28 by February 15th or move just 1.4% in the next five weeks. With two crucial earnings announcements and a storage shortage during a cold snap, that’s quite achievable.

— The Option Specialist

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About the Author: The Option Specialist