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Reviewing the natural gas investing space, an interesting anomaly has surfaced, which could provide valuable information for investors. Natural gas related equities have significantly under-performed the commodity since the rally began. Will they play catch-up? I made the case for natural gas (and UNG) to continue its climb in this recent article. Here I will look at the natural gas exploration and production stocks as a group.

A Review of the Numbers

Natural Gas has been on a wild ride over the last few years. Natural gas peaked at over $14 in 2008 and managed to give up roughly 85% of that value as it slid to under $2 in April of this year. And not surprisingly, natural gas related equities also declined during that time frame. The recent action since that April bottom tells a slightly different story however, a story not of correlation as one should expect. And this lack of correlation may be an opportunity.

To see how the natural gas related equities have moved in relation to the underlying commodity we can compare the performance of natural gas to the First Trust ISE Revere Natural Gas ETF (FCG). FCG is an ETF that seeks to generate results that correspond to the index by the same name. The Fund holds a diversified, unmanaged portfolio of natural gas producers. The main components of recent holdings are names such as XCO, STR, ECA, CRK, COG, RRC, EQT, NBL, EOG, and NFX(source: Yahoo! Finance )

In the 13 weeks since bottoming, natural gas has rallied 51.6%. In that same time frame, FCG has declined 1.7%.

What might be the root cause for this lack of correlation?

Generally the natural gas equities will be somewhat correlated to the price of natural gas. The longer the time frame, generally, the greater the correlation. The stock prices of the natural gas producers will clearly be influenced by the price of the commodity they sell. However, as the charts below show, the correlation is far from perfect. One reason is that many producers make significant use of hedges, and sell forward a significant part of their production to attempt to shield themselves somewhat from random variations in the underlying commodity. Another reason is sentiment; the decline in gas prices was so long and so severe that sentiment in the space has become extremely negative.

And of course individual names can be affected by their own peculiar circumstances that are not industry related. The widely publicized corporate governance issues at Chesapeake (CHK) are a good example.

Natural gas producers are rational and they will do all they can to take advantage of the recent trend toward improving prices. This will include a reduced use of hedges to allow for more direct exposure to rising prices. Further, sentiment is ephemeral, it waxes and wanes. Over time, if natural gas holds its gains and continues to rise, sentiment for the sector will improve.

Sentiment has already changed noticeably regarding natural gas. Worries about maximum storage capacity being exceeded leading to a further crash in prices were common at the beginning of the year and now have subsided. In the stock charts above, I have included a common sentiment indicator: the Moving Average Convergence/Divergence Indicator or just MACD. MACD measures momentum and thus reflects sentiment. The key signals are given by crossovers, which is when the MACD line (black) crosses its moving average (red). Indications of a bullish trend occur when the indicator crosses upward and above its moving average whereas a bearish trend is shown by a downward or negative crossover. For natural gas the commodity, that bullish crossover happened in May, shortly after the bottom. As you can see, FCG has only in the last 2 weeks made its bullish crossover, only recently indicating a change to positive momentum.

Conclusion

Many markets have become disconnected from their primary driver over certain periods of time. Recently, gold mining stocks have significantly under-performed the metal. But history has shown that correlations do return eventually, that anomalies do not last and that eventually "this time it is different" proves to be a fallacy. If stocks of natural gas producers do revert to the mean and play catch-up with the price of the underlying commodity, the potential for gains should be impressive.

Source: Natural Gas Equities Have Significantly Lagged The Commodity