Natural Gas Bottom Has Yet To Be Reached

Jul.20.12 | About: The United (UNG)

Natural gas has made several media headlines this year due to its incredible volatility. Earlier this year, it set all time (inflation-adjusted) lows as it fell below the critical $2.00 / MMBTU point. Immediately following this, it rallied over 30% within a month, causing it to be one of the best performing commodities in May. Since natural gas reached $2.00 / MMBTU in mid-April, it is up over 50% from its lows. This type of violent recovery can lead many to quickly ascertain that the bottom has in fact been reached and it will once again rise to previous levels not seen in several years. Such an opinion is perfectly understandable given the recent price action, but I submit that by simply examining the fundamentals of this industry, one will quickly see that natural gas could still experience several years of downside.

Natural gas is used in many different industries and has experienced a gradual increase in demand for several years. The two largest demand factors of natural gas consumption are the industrial sector and its use as a fuel for power generation. The chart below shows the consumption of natural gas for the past 15 years.

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It is important to note that demand from power generation has been steadily increasing while industrial consumption has been decreasing. The reason for the increase in power generation demand is that natural gas has progressively become a more affordable fuel source on a MMBTU basis. This has led to a concept known as coal to gas switching in which coal power plants find that it is cheaper on a MMBTU basis to use natural gas rather than coal. Progressing into the future, electric power will more than likely be the dominant source of demand for natural gas and any market participant seeking to understand this side of the economic equation should keep their eyes on this figure.

By simply examining the demand side of the market, individuals are left with an impression that natural gas use is slowly and steadily increasing and a hasty conclusion would lead to the belief that prices should progressively rise into the future. However, once individuals look at the supply factors at work, they will quickly see supply as the predominant driver of natural gas prices.

Within the past few years, the natural gas market has had an unprecedented influx of supply. This supply has largely been a result of shale gas. This article provides a good explanation of what shale gas is and why it is important. Shale gas is a huge game-changer which has altered the fundamental landscape of the industry. These type of developments typically only happen to an industry every few generations and normally they slowly and gradually drive price and market change. Within the natural gas industry, however, we are experiencing massive deviations from "the norm". This year's storage reports have painted a stark picture for individuals who are bullish any form of natural gas. The chart below shows the amount of natural gas sitting in storage within the United States. This data shows a five year band which gives a picture of how storage has seasonally behaved. Natural gas storage is typically highest in the "shoulder months", or the months between winter and summer. Natural gas storage is typically lowest at the end of winter due to the increased demand from heating and the power generation associated with heating.

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The above chart shows a radical departure from what is normal. This year our lowest amount in storage at the end of winter didn't even come close to prior years. There is a strong surplus of natural gas in storage which is only growing due to the fact that we are entering another injection season soon.

With such an overwhelming shift in the supply side, I believe that natural gas is due for a significant continued downside. At the current levels, I see UNG becoming a progressively better short opportunity as it makes new monthly highs. We are entering the injection season for natural gas in which we put more natural gas into the ground than we use and we will be in this season until October when we begin withdrawing it for heating. The recent price rally going into the injection season gives me a compelling reason to look for short opportunities in the near future.

My preference in the market is to think fundamentally and execute technically. Today's upward breakout of horizontal resistance at $20 / share (UNG) or $3.00 / MMBTU (futures) tells me to wait patiently for better prices. In order to fine-tune my entry, I have performed an optimization in which I backtest a variety of moving average crossovers to determine which crossovers were the most predictive in the past. I have included the chart of my findings below.

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I don't believe that the past is a perfect predictor of the future, but I believe that history tends to rhyme. Therefore, I'm trying to select a moving average combination that lies within a region of relative over performance in order to try and position myself best for continued downward momentum. I see that the 20 and 29 moving average crossover is one which lies within a region of over performance. I believe that this region will continue to over perform into the future, so I will treat this as my entry signal.

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Prices may continue their upward climb, but I believe that the overwhelming bearish fundamentals will eventually lead them to new lows. I'll be waiting until downward momentum resumes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.