Natural gas is one of the assets that have failed to participate in the bull market since the financial crisis. We've all probably read about why, in the financial media. It is about hydraulic fracturing. All of a sudden, the U.S. is sitting on a massive energy resource. It is so abundant that there have even been calls for U.S. becoming a net energy exporter using natural gas. However, there is an argument to be made against the fact that the decline in natural gas prices is purely fundamental. Recent developments in the price action are indicative that the asset is setting itself up for capitulation. If that happens, the resulting trade can be one of the most lucrative investments that can be made in 2012.
One should carefully assess whether the hydraulic fracturing (or fracking) story is all there is to the continually declining price of natural gas, especially in the last year. I am suspicious of the fundamental reasons for the fall in natural gas prices because there seems to be cracks in that argument. I find that, except a very few specialized investors (whose comments are very much welcome to this article by the way) almost none of us can answer some of the basic questions behind the fall in natural gas. For example:
How did a very complex technology like hydraulic fracturing become so dominant in such a short period like two years?
Natural gas persistently trades at an astonishing 300% premium to U.S. prices in other parts of the world. How can there be such a large and persistent price discrepancy in a commodity that is massively used on a global scale? Why isn't the LNG infrastructure to transport natural gas readily available and in use despite this price discrepancy? Yes, natural gas is more expensive to transport than oil but doesn't the price premium more than compensate for that cost?
The truth of the matter is that fracking technology can just be an excuse to rationalize the fall in natural gas prices. The actual reason may very well be that natural gas prices are falling because investors have given up trying to catch the bottom. Going long natural gas prices hasn't been working as an investment, so investors have simply abandoned it.
In this seemingly bottomless fall, however, probably lies one of the greatest trades of 2012. In the last three months, natural gas has been accelerating its fall and it is been setting up for capitulation. It should be noted that natural gas has been in such a strong and consistent downward trend that it will take a very strong and shocking move to reverse the trend. There should be an enormous daily crash followed by an equally astounding and quick bounce. While this might seem improbable, it is what a capitulation should look like. It should be so shocking in magnitude that it should change the status quo. The shorts should be persuaded that they have gained enough and should cover, while the longs should be convinced that it is a once in a generation opportunity not to be missed.
Natural gas is already a very volatile commodity. Therefore, we need at least a 13% -15% daily decline to mark such a capitulation event. Assessing from the charts I expect the described event to take the United States Natural Gas ETF (UNG) down to around $12, which should also serve as an entry level to go long UNG. However, what determines the bottom will not be the price level. It will be the magnitude of the percentage loss. So if the aforementioned daily decline in excess of 13% occurs around $14, that should be the level to go long.
I realize that the sequence of events that I described seems quite impossible. Natural gas is already very cheap and another 30% fall is almost unimaginable. However at the turnarounds of these long-term trends prices move quite fast and the volatility pretty much explodes. Also, given the strong downtrend that natural gas is in, the capitulation to reverse the trend should be extreme as well.
I wrote this article because as far as I can tell from the charts, we are quite close to experiencing the turnaround of natural gas. I will try to write another article when I initiate my own positions. This will probably be "the trade" for 2012, for the ones who can get in near the bottom. Natural gas is such a reliable and widely used energy resource that prices will almost surely turnaround. 2012 might be the year they do.