The Daily Trading Report

Similarities between Natural Gas (UNG) and Crude Oil (USO) are beginning to emerge, albeit with a 6 month lead/lag. The charts of USO and UNG tell us that despite all the bearish fundamentals for natural gas in North America, the time to buy Natural Gas is at hand. In February this year, when the masses thought that at best oil was going to stay at $40-$45 per barrel for the “foreseeable” future, West Texas Crude had already engaged in a bottom formation pattern. At that time volume going into the ETF USO (and other oil ETFs like OIL) shot up dramatically. As soon as volume began to subside crude (USO and OIL) began to track higher.

UNG and the smaller ETF GAZ are now showing signs of going through the same behavioral pattern with volume spiking before the market turns higher.

There are several bullish fundamental factors for natural gas.

1. The number of rigs exploring for natural gas in the US is down 50% to 700, from this time last year. We will try and keep our analysis simple…..a reduction in rig count by 50% is more than likely to lead to a material curtailment of supply over the coming months (which is hard to turn back on again if demand increases).
   
2. Supply reductions added to an increase in industrial demand and it does not take a rocket scientist to figure that gas prices are set to increase significantly.
   
3. A number of commentators are detailing how the cost of production is in the $7 – $9 per mcf region. We don’t know for sure exactly what the real production cost for Gas is however this estimate is twice the price that gas is currently trading at which suggests that at $4.50 mcf natural gas is trading well below cost in many instances (again exactly how much is open to debate), obviously this situation cannot last too much longer without additional supply cut back (which is still happening) or an increase in demand (we don’t see much evidence of that yet but remember the first material sign of a pickup in natural gas and gas futures would already have doubled from current levels.
   
4. The primary trend in commodities (aka the CRB Index) is to the upside. This will drag commodity prices higher by virtue that they are merely commodities (even Turkeys fly in a hurricane).
   

However, in order to weigh the evidence there are a number of factors to account for the bearish behavior of natural gas prices as well:

1. New shale supplies in the US and Canada continue to provide huge supplies of low cost natural gas, lowering the break-even price for operators. Although with Gas falling from $6.00 to $3.50 recently one wonders what the breakeven price is even for “low cost” shale.
   
2. The amount of gas going into storage is close to record levels – this suggests that demand reduction is still outpacing supply cut backs – by an increasingly wide margin, not by a narrowing margin.
   

However, contrary to popular belief, the bottom of every major bear market for commodities is characterized by oversupply, the more oversupply the deeper the bear market. Bull markets tend to turn bearish when supply and stocks are at relatively low levels. What many analysts fail to understand is that prices go down for a reason, the primary reason being oversupply. This leads to lower prices which leads to supply cut backs….until eventually these supply cutbacks reach an apex…….which starts the next bull market when supply cannot keep pace with increasing demand and dwindling stock piles.

We find it very difficult to find anyone who is bullish on natural gas……and any bull that does put up his hand gets it cut off by passionate bears that cite the bearish arguments above. We would like to remind our readers that winning at the investing game is more an art than a science…….it is in essence the art of contrary thinking. Yes the news flow for natural gas is bearish but perhaps prices already reflect the bearish news flow plus a whole lot more (humans are typically overly bearish at important market turning points). Use your past experiences………remember the bullish news flow last year when crude hit $150? Never forget market behavior, the news at turning points is just too strong for most people to act contrarily to it…fundamentals so intensely support the continuation of a trend just when it is ready to reverse.