August 24 Market Update - Natural Gas

By request, we're going to look specifically at the natural gas market.

We are not natural gas experts, though we do closely follow the energy complex as a whole. The issue at the core of the natural gas market is the production of shale gas, notably the Barnett Shale, which has been the fundamental game changer in terms of natural gas production.

At present, there is a massive oversupply which has been driving the price down. At the same time, the characteristics of shale well are such that they deplete very quickly. This forces them to be tapped and run hard, which floods the market with supply in the short term. The low price then forces companies to stop developing new wells, which over time, creates supply shortages. New rigs are then deployed to tap for more gas, which drives the supply up again.

Rinse and repeat. The problem that the industry as a whole will have to adapt to is inventory control of natural gas developed from shale wells. Until the industry resolves a way to adapt to this type of "yo-yo" production, natural gas prices will likely remain volatile.

With that said, here's a technical view of the problem.

First, the typical rules apply. Price is going to be heavily dependent on both the supply and demand of natural gas as well as the supply and demand of the currency it is measure in (dollars). So if the dollar rises, then natural gas prices will weaken, though probably not as much as crude oil prices because of the regional nature of natural gas. Fundamentally, natural gas needs a weak dollar, a cold winter, and some increased LNG demand to resume a bull market.

The intermediate term daily chart of the last 18 months tells the story:


Natural gas began it's crash period in conjunction with crude oil and the rest of the commodity complex in July of 2008 (July 13--the date referred to as the "Midnight Massacre" by those that listen to analyst Don Coxe).

Beginning in March, when the stock market bottomed, the rate of decline of natural gas began to slow until it entered its "basing" phase in May. A basing phase is when a security starts to build a base from which it is likely to rise again. In the chart above, this is denoted by the blue rectangle.

The RSI has turned bearish but downward momentum has slowed considerably. The direction of a confirmed "break out" from the blue rectangle is what we're looking for. If it "breaks down," the implication is that the bear market will resume and prices will be under more pressure. If it "breaks up," the implication is that we *may* return to a bull market.

The problem is, it looks as if natural gas may have broken down through the bottom of that box. It will take a few trading sessions to determine if this will happen or not (there is such a thing as a "false break down.") Let's zoom in a bit.


You can see the support and resistance lines in red on this chart more clearly. There was a break down and a subsequent rise. Natural gas really needs to hod that $3.22 line. The slow stochastic is oversold, which implies that there will be some buying. It will not be in a bull market unless it breaks $4.57 on the upside. That will indicate longer term rising prices.

Short term, natural gas looks like a buy for the next couple of weeks (the short term is the most unpredictable). Mid term, it is likely to stay within its basing range until it breaks up or down with confidence.

Let's look at the long term picture.

Long term, the chart is negative, but may be forming a descending triangle, which will force a move in prices higher or lower. We would suspect that natural gas will decide on a longer term direction within the next 6-8 weeks.

Again, if we look at the fundamentals, we see that the rig counts have dropped massively since the "Midnight Massacre" but are starting to turn the other direction. Speculation is that there is an "economic recovery" around the corner. While we're not so sure about that (again, we may have 6 more months or so of positive signs before a turn over, if we're lucky), we do believe that we're in for a colder than normal winter. While it's not a topic we have addressed here (it would be something for a newsletter versus this blog), we track and record sunspot activity as a predictor for weather patterns, which in turn help with crop forecasts and thus grain commodity prices. With a really good chance of a colder than normal winter throughout most of the Northeast and Central United States and Canada, we will likely see the price of natural gas spike and rise this winter. As the inventories rise going into the spring, we may see a repeat of a crash in prices, barring new innovations in storage management.

Being a trader's market, we're long natural gas short term. Mid term, we need to see a price break out before buying in. Long term, we're bullish, though cautious. This market is not as simple as the crude oil market, so caution is warranted as the industry makes structural adjustments.