Profit Once Pain Returns to the Pump (UGA)

Prices at the pump continue to move lower thanks mostly to declining crude oil prices and fluctuating refining margins. And at current levels, it appears that gasoline margins are relatively cheap given current supply and demand figures.

Although both crude oil and gas prices are trading under pressure, given the increasing supply from the U.S. shale producers, the price of gasoline relative to crude oil has fallen by an even greater extent. Since reaching a peak in April 2014 at $27 per barrel, the price of the gasoline relative to crude oil — known in the industry as the “gasoline crack” — has declined by 74% compared to a 52% decline in crude oil prices.

gas crack uga
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The gasoline crack — represented by the NYMEX gasoline futures price minus WTI crude oil futures price — is currently trading near $7.40 per barrel, which is below the historical average for this time of year. Over the past ten January periods, the average price of the gasoline crack is $11.50.

So the question for investors is: Why would the margin begin to rise during the balance of the winter and into the spring?

First, gasoline demand is rising. According to the Department of Energy, gasoline demand has averaged about 9.3 million barrels per day over the past four weeks, up by 4.6% from the same period last year. This came as the average price for regular gasoline was dropping, to $2.30 per gallon as of Dec. 29, 2014 — a decline of 10 cents per gallon from the week prior, and 31% year-over-year.

Second, the amount of gasoline that is available is starting to decline.


Source: Department of Energy

According to the Energy Information Administration, days of supply — which reflects how much gasoline inventory is available for use — is lower than it was at the same time last year when prices were nearly 50% higher. Additionally, the EIA also recently reported that refinery throughput averaged 16.4 million barrels per day during the week ending Dec. 26, 2014, up 36,000 barrels per day compared to the previous week’s average, while gasoline production increased to 10.2 million barrels per day.

So if gasoline demand is rising and supply is declining, at some point, gas prices should start to outperform crude.

You can benefit from this simply by trading ETFs — namely, buy a gas ETF while selling a crude ETF.

To initiate this type of trade, you would purchase the United States Gasoline Fund, LP (UGA), which tracks the movements of gasoline by purchasing NYMEX gasoline futures contracts, while shorting the United States Oil Fund LP (ETF) (USO), which tracks the movements of West Texas Intermediate crude oil. USO does this by purchasing NYMEX oil futures, cash-settled options on oil futures contracts and forward contracts for oil, and participating in over-the-counter oil transactions.

uga uso
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Since the UGA and the USO trade at different prices, I recommend that you sell an equal notional value of each ETF. For example, if you are interested in assuming a position that is $1,000 in value, you would purchase 31 shares of UGA at a price of $32.05 and short 52 shares of USO at a price of $19.20.

As far as where to take profits or set a stop-loss? Use the ratio between the two ETFs as a guide.

Currently, the ratio is at 1.67. Sell UGA and buy USO to stop out of the position when the ratio dips below 1.55 (7% downside), or take profits when the ratio reaches 1.85 (11% upside).

As of this writing, David Becker did not hold a position in any of the aforementioned securities.

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