Natural Gas: Long-Term Bull, Short-Term Bear (Part 2)

Jun.19.09 | About: The United (UNG)

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There were unexpectedly large draw downs in both crude and gasoline reported Wednesday, 6/10, and the market reacted with surprise. I don't understand that because by now everybody has certainly heard about the huge amounts of oil afloat in tankers while the big boys do their arbitrage thing, using the contango situation.

Supporting an argument for downside risk on oil is James Bibbings "Oil's Running - How Strong Are It's Legs?" article. It predicts a retracement in oil prices, which should (by conventional wisdom anyway) put pressure on NG prices. Another article, William Smead's "Don't Believe This Rally In Oil" states that the oil price rise is overdone and will come back down, sooner or later. If correct, and it does match my bias, the traditional price-ratio should leave the 18-19 range and go towards something nearer the long term average via an oil-down, not natural-gas-up, mechanism.

As just one sample of this, check James Pethokoukis' "JPMorgan hires crude tanker to store gasoil - trade". There are other articles on SA that state that Goldman-Sachs (NYSE:GS) has purchased a large quantity of oil futures about the same time they made a call for $85/$95 oil this/next year. I have no reason to doubt any of this stuff. If you do, I'd be glad to hear of it.

In Ryan Avent's "Tyler Cowen's Thoughts On America's Energy Policy" the assertion is made that although higher energy (oil) prices would help the U.S. wean itself from oil dependency, it will not happen. Actually, you need to click the link there labeled list to see the original article.

In Jim Kingsdale's "Will Oil Continue Its Rise?" the assertion is made that oil will essentially trade in-line for the next 18 months or so. He references another post therein that indicates that oil shortages may begin in three to five years.

In the first few paragraphs of June 11 Oil Market Report from the IEA it is seen that supply is increasing while demand is shrinking. Further, even the demand picture is looking bad for oil bulls. This chart from a selection under the demand tab illustrates the situation admirably.

OMB Demand Change Y/Y OECD Total

My conclusion is that if all the above indications hold, one cannot count on higher oil prices to provide a enough of a catalyst for increasing NG demand, near-term, to stimulate a rise in the price of NG even if we presumed that a ratio of price of oil and natural gas existed

That stimulation will have to come elsewhere.

Natural Gas-specific

Let's look at the very recent environment.

Thursday, 6/4/2009. another blow was delivered to natural gas prices (and, therefore, the short-term bulls) as injections came in at +124 BCF when expectations were for +115 to +120 BCF. This 3.3-7.8% higher-than-expected supply injection may be the nail in the coffin for short-term bullishness on NG. This was just the latest installment of bad news for this commodity. The next week, injection was +106 BCF, at the low end of expectations.

With these two weeks, there is still no observed decline in supply. In fact, if you look at the DOE's Weekly Natural Gas Report of June 11, 2009 you'll see storage has finally violated the upper bound of the normal 5 year range, and it gets worse the following week, as shown in the 6/18 report.

This article, "Study boosts U.S. natural gas reserves by 35%" ought to scare the bejeez out of you if you are already long NG. If you're not, just say "WHEW!".

This is now widely known by all as the CNBC folks have discussed it on-air.

From the DOE 6/18 Weekly Natural Gas Report, "Working gas in storage was 2,557 Bcf as of Friday, June 12, 2009, according to EIA estimates. This represents a net increase of 114 Bcf from the previous week. Stocks were 622 Bcf higher than last year at this time and 472 Bcf above the 5-year average of 2,085 Bcf. In the East Region, ... At 2,557 Bcf, total working gas is above the 5-year historical range." Go and check the chart for a real scare - stores are even further outside the five year average range.

In Hao Jin's "Is Natural Gas a Long-Term Investment?" you'll find a nice pie chart and conclusions contained in an EIA report that is bearish on long-term NG prices - 7 years flat prices!

Wednesday, 6/3, CSU predicted a milder hurricane season (reduced risk of supply disruptions). Thanks to Freya, who turned me to Joe Bastardi, of Accuweather, for more comprehensive long-term forecasts. The first result of using that is an increased near-term bearish outlook due to this from Mr. Bastardi, as he also calls for a milder hurricane season. He does, however, warn that the gulf states may still see some more severe storms.

An important addition, in my opinion, was this. "According to Long Range Expert Joe Bastardi, areas from the northern Plains into the Northeast will have a “year without a summer.” The jet stream, which is suppressed abnormally south this spring, is also suppressing the number of thunderstorms that can form ..."

So that should translate into less NG use for peak generation capacity. A potential offset to that may be that NG prices get so low that utilities start using more natural gas and less coal, where those utilities have the facilities. For those that don't have it, they may be able to buy electricity from other providers since prices could be favorable, assuming even marginal excess generation capacity by some of the larger utilities. This would tend to raise (marginally?) and then stabilize NG prices at some level.

A flat-to-lower NG price trend seemed to be the opinion expressed in the Henry Hub futures too as the prices don't really begin to increment substantially until well after the summer months. Even then the November futures were only at $5.00 (at 09:45 6/11/2009), down a penny from 6/40.

Further, that same day oil inventories reported an unexpectedly large growth, +1.55MM bbls. That applied downward pressure on oil prices, and through association, other energy prices. What I noted about this association is that a price linkage between oil and natural gas operates sometimes. I've not yet had time to investigate a potential pattern to this linkage.

It apparently doesn't matter that demand for oil and gas is still down big-time, they just keep pumping. At some point the pain will be enough to stop that behavior I guess.

But the good news just keeps on coming.

The evening of 6/3, Bill Perkins, an energy trader based in Houston, in after-market comments, said NG storage is "near overflowing" (later confirmed by the EIA reports above) and he's shorting NG. He sees no near/intermediate-term catalysts to reverse the trend. So, regardless of my "expertise" (there is none that I know of), we should seriously consider giving credence to him, especially with all the other facts and technical indicators supporting his view.

Adding to the dismal outlook, look at the front-month price close of the Henry Hub futures, from 6/2 close to 6/3, as seen in these two snapshots.

Nymex Henry Hub Futures, 6/2 Close

Nymex Henry Hub Futures 6/3 Close

You can see a 1-day drop of almost $0.13. And with the news 6/4, the "hits" just kept on coming. In the morning trades, the futures were down big. Even as other commodities destroyed on 6/3, including oil, gold, silver, etc., recovered and were trending up, at 13:28 NG was down $0.08 to $3.766.

If you want to take a look at the Henry Hub prices, here's one place you can go.

As of last month, shut down wells had only achieved 54% off the huge number of wells that had been attained in the various shale plays and other places over the last couple of years.

All I can surmise, with the huge oversupply vs. demand, is that the drillers must be a masochistic lot and need more pain. At some point, the weaker of those will adjust.

There have been several posts indicating that a lot of LNG may be coming to our shores from the middle east next year. I think this may not materialize because of other economic factors which I'll mention in my next post for the long-term bull case.

UNG Specific

Regardless of the 6/11 DOE report cited above, morning trades on UNG were up $0.45 at 12:02, confirming my suspicion, noted in my working document, that it would rise just because the pattern on the high volume days has predominantly been one of reversals - down day followed by up by down, ... If I were a gambler (hmm, trading stocks in this. environment, maybe I am) I'd bet close up and tomorrow down again. But if there's any correlation to reality, maybe not up as big as other recent times.

Volumes still unbelievably high - big boys will squash us like bugs if we're not nimble.

As mentioned earlier, the dollar entered a short-term nose-dive pattern and oil and commodities began to take off. Lots of folks continued to pile into UNG, expecting NG, and therefore UNG, to take off with oil I suppose.

In FuturesTrader's Comments in an article by Jim Letourneau: "Natural Gas ETF Jumps on No News - Turning Point?" it is pointed out that there are no distributions paid by UNG, you get taxed on "contract income" as well as capital gains, 100% of the futures are rolled at expiration each month (incurring fees, selling low and buying high due to contango) without adjusting the UNG share price to account for this (in other words, a built in loss unless there was a price movement in direction and magnitude big enough to offset this), and so UNG does not track NG prices very well.

In a tunaman4u2's comment to "Time to Go Long Natural Gas and Short Oil?", asserting manipulation, it is stated "Its usually at its low pre-inventory report... don't forget the contracts rolling soon... people dump the front month that don't want to take delivery & pile into month 2 before UNG does". I felt this deserved investigation to see if a pattern similar to what he states could be observed. So I made a chart of the closing price over the last six months and got a schedule of closing dates.

Natural Gas Futures Expiration Dates - Nymex Click to enlarge

Regardless of any manipulation, pay attention to the volumes and constant reversal of price directions on the chart below.

My "raw comments" blog at SA contains a running commentary, a "stream of consciousness", of what I've been observing. I won't burden the readers with that.

As of now, I'm not updating it anymore. It takes a lot of time and I've reached my conclusions. It will be resurrected if and when needed.

I will only say I'm staying away - I don't like getting crushed on the wrong side of a trade and this is certainly not investable in my humble opinion. If those volumes are mostly retail investors, the sell-side is stripping them of their wealth right now.

UNG 180 Day closing with Exp. Dates. NotedClick to enlarge

I've not had time myself to see if there is a discernible pattern of manipulation. Since next week is expiration for the July futures, I don't know if we would yet be seeing the suspected manipulation if there is any.

Regardless, I thought we should see if UNG tracks the natural gas prices fairly well. On first glance it seems so.

NG vs. UNG 6/18/2009 14:45

Another concern appeared on the Dow-Jones Newswire yesterday about a possible shortage of shares for issuance by UNG.

UNG Volume Causes Share Issuance IssuesClick to enlarge

My conclusion is that UNG is only a trade, not an investment. Investors should stay away, for now at least, and traders should be very nimble and astute in the sighting of trends and reversals.

Closing Thoughts

Now, for the long-term investor, I believe NG will be a big winner. There are catalysts already in play that may aid this case. I will post later when I can do the proper job of presenting what I believe and may discover with further research.

But for now, I would not recommend entry for the long-term investor.

Entry here would, I believe, be an emotional trade. And we know we should not trade on emotion. All of us who believe in "green" must exercise self-discipline to avoid this lethal "emotional investment/trade" trap. When I entered it, it was initially an investment thought but I quickly (remember nimble?) converted it to a trade when I saw the trend. I entered when an uptrend was underway and exited with a profit. If you just can't resist the urge to get in, treat it as a trade, not an investment for now. If you don't have the discipline to do that and absolutely have to get in, at least reduce your risk and (opportunity) cost by using options as the vehicle. Others have suggested playing the futures (or mini-futures) directly. If you still choose UNG, wait for a good entry point, which I believe exists below $13.50 (note: I've not adjusted this to account for Thursday's updated conditions). It might even get into the high $12 range, but let the charts guide you.

So, why do I recommend this? Simple. Capital costs. An entry for long-term here would tie up your capital with little gain for a long period. There is an opportunity cost associated with any investment. That same capital can be used in the interim to generate more capital that can be invested in NG later on, when the time looks right. Think in terms of "compounding".

I hope these thoughts help someone besides myself. I apologize if the article seems a little choppy, I really pushed to get it out today.

Disclosures: No current position in UNG or any energy stock. I do hold some stocks that may benefit from lower NG prices but they are investments that I hold, and will continue to hold, regardless of NG price.