ATLANTA – With any major market reversal trade it is essential to first develop confidence in the trade. Confidence enough to deploy capital in a suitable investment vehicle (and in enough size) to make it worthwhile. Then, to carefully and methodically design and execute the entry side of the trade to capture even lower prices than we might expect. Then, to design and execute the exit of the trade so as to get paid and experience the “fun part.” Simple enough?
While we can reasonably determine within fairly narrow limits where a market should find overwhelming support based on real time and historic data, we cannot know in advance just how much of those limits the market will ultimately give us to work with. Another major unknown is the timing, so we have to design the trade in a way that works with the maddeningly fickle market on its timeframe, not ours. (More about this in a moment.) Now, we also have the hand of government or “G-factor” to worry about with some investment vehicles, which we also touch on below.
Reversal for natural gas looms
On May 4, following a brutal 10-month “death plunge” of more than 75% in the price of natural gas (NG) -- all the way from over $13 per MMBtu to less than $3.30 for the first time since 2002 -- we suggested that the relentless downward march of the price of NG was probably nearing its nadir for this cycle. In that report, available at this link, we used a three-year weekly graph to show the NG market’s very steep, ski-slope-like profile.
Incidentally, the price action over the last year for NatGas shown below bears an uncanny resemblance to the normal production profile of many of the new “tight” shale gas wells. That is, they come in strong, but then decline rapidly and must be replaced if production is to continue from the field at the same level.
Below is the chart from that May 4 report then, and below it, the same chart now for instant comparison (two charts).
Chart from the May 4 Got Gold Report:
The same 3-year weekly chart as of July 17:
Natural gas has indeed formed a volatile consolidation since that May report, but has yet to definitively break out to the upside. Two premature breakout attempts (May and June) have been driven back, but so far NG has not been able to move materially below its April low either. At least not yet.
Consolidations often mark major turning points, but the periods of market indecision can also form as a kind of roadside stop before the trend continues in the same direction. Until there is a definitive move, either up or down, we really don’t know which master this particular consolidation serves.
Our basic premise for NG can be boiled down into one (compound) sentence. NatGas is not going to zero; it is cheap relative to most any way one can measure it; it usually reverses in high percentages well before the fundamentals suggest it should and we want to be on board and get paid when it does.
Why do we suspect that NG will eventually reverse the downtrend and move significantly higher? Because that’s exactly what it has done following previous major, more than 70% “death plunge” price collapses. Does that mean that NG will absolutely do that again this time? Well, no, it doesn’t guarantee it, but then we are not aware of any high-opportunity trade that is guaranteed.
The best we can do is to study the history of the market and use that knowledge to anticipate the current market enough in advance to have some trading “fun.”
For historic context, for confidence and to further support the idea that NG was probably nearing its ultimate nadir, we employed a longer term, ten-year monthly version of the NatGas market which clearly showed what happened in the last major “death plunge” for NG in 2001 and its dramatic two-stage recovery in 2002. Below is that same ten-year chart from May and below it, the same chart now in July for comparison.
The 10-year monthly chart from the May 4 report:
The same chart as of July 17:
We’ve already laid out the basic reasoning to accumulate NatGas via the ETFs and the producers in that May report and several subsequent reports, such as a follow up on June 26, so we won’t repeat all of it here.
Government meddling headaches
As can happen when government politicos, flamboyant televised market mavens and newly empowered regulators decide to show their testosterone, the “Big Gas Bears” (“BGBs” – the big spec funds heavily short NG) got an assist in the form of a strange-timing assault on energy ETFs and commodities investors as we highlighted in a July 8 report available here.
Despite that “full court press” assault on natural gas and on the energy ETFs, the best that the BGBs could do was to move the low for natural gas down by three cents from its April $3.25 bottom. Those who continue to be bearish of NG must be sorely disappointed. NG bears are apparently once again growing nervous. And they certainly should be.
On Thursday, July 16, the Energy Information Administration (EIA) reported a net implied injection of NG into storage of 90-billion cubic feet (bcf), which is about in-line with the 15-year average injection for the weekly reporting period. The instant reaction of the market to that news was for both NG and the NatGas ETFs which track it to rally over 10%. The trading action is clearly visible in this short-term hourly chart for the United States Natural Gas Fund (UNG) just below.
How interesting. Are the NG shorts really that nervous that they would rush to cover on an average-sized NG injection into storage? There must be more to the story than that.
Apparently NG bears had expected the injection to be much larger than average given the milder-than-normal weather for much of the country over the previous three weeks, CFTC jawboning and repeated negative stories in the press about industrial demand reduction. That begs the question; what would have happened had there been much warmer than normal weather for the period? What would have happened had there been an early-season named storm about to enter the Gulf of Mexico? And by the way, what happened to global warming? Grain traders now fear an early frost.
If natural gas is really as over-supplied and overly abundant as the BGBs contend, then why wasn’t there a much larger-than-average addition to the NG inventory this past week no matter the weather?
Following a four-week flag-style retrace, NG producers surged hard to the upside, gaining just under 10% this past week as shown in the XNG index just below. Importantly, the index was advancing prior to the EIA inventory release.
Notice, please, that the pullback from the June turning high checked up bullishly precisely between the Fibonacci 50% and 61.8% retrace levels and did so convincingly.
As further support for our longer-term confidence and the merits of the trade, we provide several compelling valuation comparisons just below.
First, the most obvious: The companies that produce natural gas are already pricing in higher NatGas prices. Indeed the companies remain very significantly over-valued relative to the commodity, which means the market believes they will see higher NG prices in the not-too-distant future.
While there is no doubt that higher oil prices have helped the XNG component company valuations, what that chart says is that NG is extremely cheap relative to the companies that produce it as of July 2009.
Next, NG is extraordinarily cheap relative to oil, but perhaps the sell-oil-buy-NatGas trade is getting underway in earnest now, because we note that the ratio is beginning to revert toward the mean a little.
Finally, when we compare NG to the one true “currency” and only real money on the planet, gold, we find that NG is near its historic extreme “cheapness” to gold. For example, it currently takes about two and a half times the amount of natural gas than the ten-year average to purchase an ounce of gold. It takes about 3.5 times as much as it did in July of last year and about 8 times the amount of NG to buy an ounce of gold as it did in October of 2005. Either gold is too expensive or NG is too cheap or both.
One high-profile vehicle for trading natural gas, the ETF UNG, also just recently printed a slightly lower low than our first May mention of it as shown in the chart below.
Frankly, the adverse publicity directed toward UNG by uninformed market mavens and misinformed politicos in recent weeks has been unfortunate. UNG now commands an over $4 billion market cap and has issued all the shares it can until the Securities and Exchange Commission (SEC) approves a June request by the fund to increase the number of shares it can issue by one billion. The fund actually traded at a premium to its underlying net asset value according to recent news reports.
UNG has come under verbal fire by regulators at the CFTC (who are probably listening to the screams of the BGBs) because it uses futures and options for its NAV basis. So many people have piled into the UNG fund so fast (it increased almost five-fold in assets under management in just the past quarter) that some market watchdogs (and probably BGBs) complained that the fund controlled too much of the futures markets. Their argument is that the action of the fund was “propping up natural gas prices.”
We find that argument specious if for no other reason than its timing, when natural gas prices were at lows not seen since the great NG bear in 2001-2002; at a time when NG prices are at extreme lows relative to oil and gold; and following a massive 75%-plus plunge in price. If the hundreds of thousands of investors who have used commodity pool ETFs in general and UNG in particular really have been “propping up the natural gas market” it has certainly not propped it up very much.
Interestingly, in a June 16 public comment to the CFTC, David Gerber, wrote to the CFTC on behalf of United States Commodity Funds LLC, on the subject of a proposed concept release by the CFTC which could eliminate the bona fide hedge exemption for swap dealers and might create a new limited risk management exemption from speculative position limits. In that letter Mr. Gerber said in conclusion that funds such as UNG are passive; that the fund’s structure precludes manipulation; that the fund merely tracks the price of the commodity; that even though the size of the fund has increased dramatically the action of the fund has not disrupted the market all while adding valuable liquidity.
What Mr. Gerber did not say, but we might have wished he did, was that a primary reason for investors to seek direct exposure to commodities in general and energy in particular is because of the horrific damage which has been done to the value and credibility of the U.S. dollar. People want to own “stuff.” People recognize that the anti-business, anti-energy, anti-drilling initiatives and regulations of the past and present represent a virtual guarantee of government-caused scarcity and reliance on foreign sources in the years ahead.
Mr. Gerber of the USCF concluded his comments with: “Although the futures positions held by the Funds (USO, UNG et al) may appear large in relation to each Fund as the legal holder of such positions, these investments represent the aggregation of demand from tens of thousands of individual investors seeking to reduce their financial risk though hedging in the commodity futures markets.”
Before moving into the conclusion section just a quick aside to say I’m looking forward to presenting and meeting some of you at the always exciting and stimulating New Orleans Investment Conference to be held this year at the Hilton New Orleans Riverside October 8-11.
The New Orleans conference has always boasted an impressive speaker lineup, but this year conference organizer Brien Lundin has outdone even himself with a power-packed menu of experts and savvy intellectuals in both business and politics. Including Dr. Marc Faber...Dennis Gartman...Peter Schiff...Dr. Stephen Leeb...Doug Casey...Rick Rule...Adrian Day...Frank Holmes...Bob Hoye...Bob Prechter...Dr. Mark Skousen...Ian McAvity...Pam and Mary Anne Aden...Brent Cook...David Coffin...Lawrence Roulston…Thom Calandra and many, many more.
As of right now there are still spaces available, but as always they are going fast. For more information or to reserve for the conference please use this special link and send me an email note if you plan to attend so we can connect there. It should be fun and very, very useful.
Oh, and before I forget, congratulations are in order to my good friend Thom Calandra whose Ticker Trax on Stockhouse.com “planetary prospect” Biocryst Pharmaceuticals (BCRX) just scored a moon-shot 250% rise for a no-nonsense minimum “two-bagger” from his original recommendation on news this past week. Congrats Thom, nice call.
I’m a holder of several of Thom’s “PPs,” a few of his “IVs” and a paying subscriber of Ticker Trax, but missed owning BCRX for the big move. “You can’t dance with all the girls.”
Summing up: Recent price activity suggests that those on the short side for natural gas who were emboldened by the recent verbal intervention by CFTC regulators and well-meaning but misguided politicos have become less bold, perhaps even nervous. But make no mistake about it, the public appearances and statements of CFTC Chairman Gary Gensler and Commissioner Bart Chilton were clear shots fired across the bow of funds and portfolio managers that they and all their investors are in the CFTC crosshairs if they participate in the futures markets via ETFs.
What we fear is that under the cover of “using all existing authorities to insure market integrity,” what the CFTC actually plans is to severely limit participation in the futures markets from the long side which would tip the balance of power to the short side. While that might have the short-term effect of artificially keeping energy prices low (it might actually have a perverse short-term opposite effect) and enriching the BGBs (who shouldn’t get cocky, they’re next), it also might trigger a cascade of unintended consequences.
Back to our original thesis, natural gas is cheap energy and although it is presently abundant and inventories are at historic highs we believe the current onshore rig utilization rate, at less than half of last year will not be able to maintain production at high levels. We believe that many of the new “tight” NG wells brought on line over the past three years will decline rapidly in production. We believe that overall NG production is set to plunge just as we head into the peak of the Atlantic hurricane season and the all-important fall-winter heating season.
While it is always dangerous to bet on the weather, we believe that the recent milder-than-normal summer temps for most of the country should (repeat should) have resulted in over-sized NG injections instead of the in-line injections in recent weeks, thus we are probably already seeing the beginning of the decline in overall production.
We believe that NG is already too inexpensive, especially when compared to oil and gold and while we cannot know if NG has already cut its lowest low of this cycle we do know that if it prints even lower lows we want more exposure to it, so convinced are we of the current set up.
Having said that, we now have a dark cloud hanging over the ETFs which provide direct exposure to the oil and NG markets via the heavy hand of an overly interventionist government which has already shown it thinks a government bureaucrat knows better than the free market what prices should be. Thus, while that unsettling dark cloud of intervention hangs over all investment funds which use futures for their basis, we have to recognize there is the potential for artificial, game changing risk. Risk not from market forces, but from government meddling.
In simple Texas terms, the risk is that the central planners now in power will determine that too many people want to invest in the funds – therefore they are “bad.” God knows we can’t have something that too many people want to invest in!
Before that dark cloud entered the picture it was a simple matter of designing a buy-down ladder which added UNG in small, incremental units at progressively lower targets so as to build a reasonably priced average entry ahead of the inevitable NG reversal higher. So simple, even a Geico caveman or a “50-something” Texan could do it.
Now, with that “G-man” uncertainty looming, it’s just not as clear cut.
The CFTC plans to hold hearings on position limits in the weeks just ahead. We can expect the politicos to forget that the ETFs represent the savings of tens of thousands of American investors. We can expect that some of the commentators will describe these trust funds and commodity pools as “evil speculators intent upon driving up prices at the pump” for soccer moms. We fully expect to hear that ETFs have “driven up prices of natural gas at the Henry Hub” despite the fact they are at historic seven-year lows.
So, we have to allow for the possibility that those now in power could change the rules so dramatically that it could disrupt the markets very short term. A risk is that the current leadership at the CFTC will force USO, UNG and similar funds to radically change their operations, the way they are structured or derive their basis. Another risk, while probably small it would be lethal, is that futures-based commodity pools are outlawed altogether “for the good of the country.” Sadly, we believe the current crew voted into Washington approves of the idea of radical change. They seem drunk with it.
Highly disruptive actions are possible between now and the fall-winter heating season, so we can understand if investors decided to shift their focus from NatGas ETFs to more traditional producing companies. For our own accounts we intend to continue to employ both ETFs and the producers, but not without carefully managed, long-dated option protection just in case.
Sooner or later the price of NatGas will correct the current relative value imbalance, Big Brother notwithstanding.
That’s it from Atlanta this week. Until next time good (vulture) hunting, good trading and, as always MIND YOUR STOPS.
The above contains opinion and commentary of the author. Each person should study the issues carefully and, as always, make their own informed decisions. Disclosure: The author currently holds a net long position in iShares Silver Trust, net long natural gas ETF UNG, long Timberline Resources (TLR), long Paragon Minerals (PGR.V), long Forum Uranium (FDC.V), long Natcore, (NXT.V), long Odyssey Resources (ODX.V), long Radius Gold (RDU.V), long Columbus Gold (CGT.V), long SDS as a Big Market hedge and currently holds various other long positions in mining and exploration companies. To contact Gene use LLCCMAN (at) AOL (dotcom). \
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