Natural Gas: Non-Commercial Traders Too Short?

Last week, I wrote about the extreme net positions of traders in the natural gas futures and options markets. I took the middling opinion that, because of the extremes in sentiment, the price of natural gas seemed poised to move sharply higher or lower. I’m a long time natural gas stock bull, so here’s my case for the bullish trend in price to continue. The latest Commitments of Traders report, issued Friday (14 March) afternoon, showed that the non-commercial traders had again increased their net short position to a new record level, while the commercial traders had also reached a new record net long position. The non-commercial traders have been building an increasing net short position since late last August, against which the price of natural gas has been steadily rising. With reports of significant losses in funds (1, 2) that are, or were, short gas, I thought it might be interesting to take a look at recent instances when the non-commercial traders had reached extreme net short/long positions.

During the last 18 months, the non-commercials have taken extreme positions on two occasions. The first, in 2006, occurred as they built a significant net long position from late August to late October of that year. In September, during the peak of non-commercial bullishness, the Amaranth fund reported huge losses betting on expectations for rising gas prices that failed to materialize. Just prior to the announcement of losses by Amaranth, the non-commercials had a short/long ratio of roughly 2-to-3.

The second extreme was reached near the end of July 2007, as the non-commercials became increasing bearish during a general natural gas price decline from January through July. At the peak (or trough on the chart below), the non-commercials had a short/long ratio of nearly 3-to-1. Peak net short coincided with a price bottom in July. They then decreased their net short position as gas prices had a sharp, quick rise and fall from late July to late August. The non-commercial traders then resumed increasing their net short position just as the price made another bottom and, overall, have been steadily increasing their net short position through today. Currently, their short/long ratio is roughly 2.25-to-1, but this is on nearly double the number of positions compared to late July 2007.

Despite the duration of their current large net short position, and the resulting losses, the non-commercial traders are continuing to increase their bets. Should natural gas prices decline, they may recoup their losses and much more. Unfortunately for those shorting this market, there doesn’t seem to be much help coming their way. The weekly inventory numbers showed working gas in storage ~4% above the five-year average, but ~10% below last year’s level. This reflects the recent announcement by NOAA that this winter was the coolest for the U.S. and the globe since 2001. Weather forecasts for the remainder of March are for normal-to-below normal temps in the Midwest and East, so natural gas inventory draws will be at or above normal for the remainder of the month. Also working against a decline in price are reports of liquefied natural gas deliveries going to foreign ports, thus reducing anticipated deliveries to the U.S. Continued weakness in the dollar, with more interest rate cuts expected, may provide further price support. Finally, I seriously doubt the commercial traders would be so bullish unless they perceive the pricing environment to be strongly in their favor.

The non-commercial traders certainly don’t get every market wrong, and they may yet prove correct in this one. However, when they reach extreme positions it seems, at least recently, to be a contrary market indicator. Given the size of their net short position, and supply/demand developments in the natural gas market, I’m expecting the price of natural gas to rise sharply and for more reports of fund losses to appear.

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Disclosure: The author is long natural gas stocks and options