The Natural Gas Debate From A Macro Perspective

by: Macro and Cheese

There's nothing like a 10% rally like we just saw in natural gas to focus the minds of the market participants. Tuesday morning's Seeking Alpha home page featured two headlines on natural gas, one just above the other:

"No Sign of Natural Gas Glut Ending Anytime Soon"


"Is It Time for Natural Gas Prices to Rebound?"

I am a global macro portfolio manager, and not an expert in the energy sector, but I do trade natural gas, especially when the market gets interesting. Right now, natural gas is extremely interesting.

Because I don't regularly operate in the energy sector, I'm not versed in the minutiae of supply and demand for natural gas. I do, however, fully appreciate that, from a price standpoint, the market is in horrendous shape. The frackers are fracking, oil producers are burning off their natural gas byproducts due to overflowing transport lines, and the weather has been balmy--53 degrees here in New York City today.

Instead, I take a larger picture view of natural gas, and watch its price relative to other forms of energy. One relationship I find of particular interest is natural gas and crude oil. The pair is interesting because a stable correlation between the two does not exist. Last October, for example, the correlation between UNG (NYSEARCA:UNG) and USO (NYSEARCA:USO) --- the natural gas and crude oil ETFs-- had a 60-day correlation of .909, before plunging to a negative correlation, -.82, by mid-December. The longer-term weekly correlation of the two is only .29.

Yet as you can see in the chart below, the markets are clearly related:

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Specifically, the two are co-integrated, meaning they don't necessarily move in the same direction at the same time, but yet they are not independent of each other, and tend to converge at various points in time.

The most compelling explanation is the simple economic one, namely, that both commodities are subject to supply and demand, and that, to some degree at least, one commodity can act as a substitute for the other. When the price of oil is too high, producers are paid to increase supply. Conversely, if natural gas prices are too low, producers cut costs and boost price by decreasing production, as we saw with Chesapeake Energy (NYSE:CHK). If crude oil were to skyrocket and natural gas were to remain at distress levels, we would begin to convert vehicles to run on natural gas.

As we can see from the chart, the two markets have never been wider apart. In other words, relative to crude oil, natural gas has never been cheaper. Back in May 2007, it cost less than half a share of UNG to buy one share of USO. Last week, on January 19, it cost 7.69 shares of UNG to buy one share of USO. This is a compelling ratio. We also see that prices of natural gas have hit a level not seen since 2009.

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Furthermore, as we see above, the impressive bear market in UNG accelerated starting in the fall, with the price falling from $9 to the January 19 low of $4.98 in a few short weeks. This last leg has been the most dramatic and comes on the heels of a very long downmove that has lasted roughly three years. We can also see that volume has picked up substantially over the past month, with volume hitting triple the average of December on several trading days this month.

This is a classic blow-off. We have a parabolic downmove that accelerates to new lows on rising volume, accompanied by stories of infinite, unwanted supply. But then something occurs, and the market reverses in dramatic fashion as participants realize prices have been marked down too far. The event is often a catalyst for a reversal, and in this case, the catalyst was Chesapeake moving to restrict supply.

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Finally, in the chart above, we can see that although UNG prices did not hit their price low to date until January 19, the amount of outstanding shares hit their lows at the end of the third quarter of last year. We can see from the chart that the number of shares outstanding has tended to lead the market by several months, consistent with a trend reversal. It appears that investors have begun to accumulate UNG, and since those investors have been bottom-fishing, they're probably in strong hands.

There is no doubt that the fundamentals for natural gas are bearish, based on the stories that have flooded the press. As we know, markets adjust to the news, and in the case of natural gas, has duly collapsed in dramatic fashion to accommodate the bearish information. But now Chesapeake Energy has changed the dynamic by announcing that the supply side of the equation has been altered. When supply is reduced, prices head higher.

It is possible that Chesapeake Energy acted out of turn, or alternatively, that the weather continues to remain unseasonably warm throughout the winter. Natural gas is notoriously volatile, and certainly lower prices are a possibility. But given the strength of crude oil and the technical indicators, such as an increase in outstanding ETF shares, odds favor a rebound, if not a material change in trend.

Disclosure: I am long (UNG). I have a long position in natural gas futures.