Whilst many will argue that the fundamentals for natural gas are bad we would urge readers to note that fundamentals always appear bad at the bottom of a market and conversely at the top of the market they appear infinitely positive. Of course in investing the trick is to see through what is and consider what is likely to be. To be honest we have no idea of where the bottom of the market for natural gas is. However, we do know that as of late many of the signs of a bottom formation for natural gas are in place.
Perhaps we are too contrarian for our own boots at times but this is for good reason. Over the years we have learnt (yes the hard way) that “when everyone thinks alike they are most likely to be wrong”. Bearish sentiment towards natural gas appears to be at record highs, or if not certainly at extreme levels. There are a power of reasons why natural gas prices are as low as they are (why else would they be so low) and now we are beginning to hear how there has been a “fundamental change” in the natural gas market. Amongst others there are arguments that the natural gas ETF UNG is driving prices (as its cousin USO is driving crude prices), that cheap supplies of LNG are coming to market, and that cheap gas supplies from shale mines are keeping the price of gas low. We don’t know what is fact or fiction but we do know that when we hear the words (albeit words to the effect) “this time it is different” the more likely it is no different than before.
We do know that natural gas stock piles have increased dramatically over the last few months as demand appears to have fallen. However, supply cut backs have been equally dramatic. Natural Gas rig numbers have fallen the most in modern history over a rolling 12 month period (a fall of approximately 56%) and there appears to be no let up in the numbers falling over the last few months. From contacts in the oil and gas drilling industry we know that the longer a rig is shut down the time to get it back on stream increases exponentially. In addition it is a relatively simple task to shut a rig down but it is a much more difficult task to get it back on stream. We suspect that (as per usual) operators will overdo the supply cut backs and when demand picks up stock piles will fall rapidly because supply will be unable to keep up.
From a technical perspective there has been no change in trend in Natural Gas futures. However, note from the chart below how the rate of change (ROC) has begun to diverge from the price of natural gas itself. We have seen this behaviour occur time and time again in the commodities market and generally (80% of the time) it signals that the end of the trend is very near. Also note the increase in volatility over the last couple of months. Changes in trend are generally preceded by a material increase in volatility.
How long can crude oil and natural gas prices diverge in an absolute sense? Something has got to give, either crude oil prices have to fall to meet natural gas prices or natural gas prices have to rise more dramatically than crude. Our call is that commodity prices in general have entered a bull market (click here for our discussion on the commodities market) and accordingly crude oil prices are more likely to rise over the coming weeks/months than fall. So we think that it will be the natural gas bears that give. What would be a fair price for natural gas? We don’t know but if history is anything to go by it appears that natural gas is trading at a comfortable 50% discount to crude.
We don’t like following the herd. Technical junkies are probably watching the $4.50 level in natural gas futures for confirmation of a breakout. We have seen enough evidence that the next move of significance is likely to be to the upside. We are positioning ourselves accordingly. It may take a few months to play out, and we may be wrong before we are right. But we can afford to wait – good things take time!
At Glenorchy Capital we constantly search the globe for value opportunities across asset classes. We discuss these opportunities in detail with subscribers.
