Natural Gas Flirts With Upside And Downside

About: VelocityShares 3x Long Natural Gas ETN (UGAZ), Includes: BOIL, DGAZ, FCG, GASL, GASX, GAZB, KOLD, MLPG, UNG, UNL
by: Andrew Hecht

Range trading in natural gas.

Just shy of a triple-digit injection.

The range narrows from 2016.

Open interest reflects changes in the market but could be building pressure.

Trade the range.

The price of natural gas hit its most recent low at $2.722 per MMBtu on May 7, just after the withdrawal season from inventories came to a late end because of the April storms that increased demand. The energy commodity hit a high of $3.661 in late January, but natural gas made lower highs in February, March, and April leading to its early May nadir.

We moved into the withdrawal season last November, one week early and exited around four weeks later as the winter lasted longer than usual. Inventories moved into the season of peak demand at the lowest level in three years at 3.79 trillion cubic feet. During the prior two years, natural gas stocks reached consecutive records at over four tcf. The length of the season led to the lowest level of stockpiles since 2014 at 1.281 tcf when they finally found a bottom.

Instead of focusing on the low level of inventories over past months, the market looked forward to the injection season as massive reserves of the energy commodity from the Marcellus and Utica shale regions of the U.S. would quickly replace the stocks to prepare for the winter of 2018/2019. While natural gas has been flowing into storage over recent weeks, the price action has been surprisingly firm. Since late May, the July futures contract has made three attempts to move above the $3 per MMBtu level, which remains elusive. Each time it has risen to the top end of the trading range, selling has pushed the price back down to lower levels. Natural gas is attempting to form a new and higher trading range over recent weeks.

Range trading in natural gas

July natural gas futures have moved to a range where the highs from March 15 through May 15 have become the lows.

Source: CQG

As the daily chart highlights, over the past few weeks, natural gas futures have traded in a band from around $2.85 to $3.00. While a 15-cent range is fairly sedated for the historically volatile energy commodity, the price action has moved to a new and higher level. Open interest, the total of open long and short positions on the NYMEX natural gas futures market, has increased to 1.557 million contracts as of June 7. The all-time high in the metric was at 1.56 million back in 2013, so market participation in the natural gas market is close to an all-time high, even though the price range has been less than exciting. The daily chart shows that price momentum is moving lower in neutral territory. The weekly chart shows the opposite, and a bullish trend albeit in overbought territory, while the monthly pictorial is close at close to an oversold condition and is attempting to cross to the upside. Meanwhile, the monthly historical volatility measure at below 16 percent is at the lowest level in years, which is a reflection of the moribund state of the price action in the natural gas futures market. Technical support is at $2.722 per MMBtu on the July contract which critical resistance at the late January high of $3.01. On May 29, the price made it to a high of $3.00 which was the first of three attempts to move above the level that could signal a technical break to the upside. The narrow price range, and repeated failure to break higher or lower over recent weeks makes the rise in open interest a quandary. However, the higher trading range could mean that the increase in long and short positions is a bullish sign for the energy commodity that refuses to scale above the $3.01 per MMBtu level, so far. July natural gas futures were trading at just under the $2.90 level on Friday, June 8 which is at the middle of the trading range.

Just shy of a triple-digit injection

Last Thursday, I had expected that the EIA would report a triple-digit injection, but the number came in slightly lower than my expectation at 92 billion cubic feet.

Source: CQG

As the chart shows, while the amount of natural gas in storage has risen from 1.281 to 1.817 tcf since the injection season commenced last month, the stocks remain 30.5% below last year's level and 22% under the five-year average as of June 1. At the same time, the injection numbers last year and the average of the past five years were over the 100 bcf level which means that demand is higher which is consistent with what we are witnessing in other energy markets. The level of crack spreads, or the economics of refining a barrel of crude oil into oil products, is appreciably higher this year than last at this time. Crude oil processing spreads are an indicator of demand for gasoline and distillate oil products. The bottom line when it comes to oil and gas is that production is increasing, but economic growth has led to an increase in demand.

The range narrows from 2016

Since its introduction in 1990, the NYMEX natural gas futures contract has traded in a range from $1.02 to $15.65 per MMBtu. Over recent years, the band has narrowed near the bottom end of the trading band.

Source: CQG

As the monthly chart illustrates, over the past three years, we have seen a narrowing trading range. In 2016, natural gas traded from $1.611 to $3.994, a $2.383 per MMBtu range. Last year, the range narrowed to under one dollar at 90.9 cents on the continuous futures contract. So far in 2018, the range has been from $2.53 to $3.661 or $1.131 per MMBtu. Even the range in 2016 is a far cry from past years. In the wild years of 2005 and 2008, the trading band for natural gas was $9.92 and $8.484 respectively. Interestingly, interest in the market is far greater these days than during the heyday of volatile conditions when speculators flocked to the natural gas futures arena.

Open interest reflects changes in the market but could be building pressure

The natural gas market has matured and evolved in the United States over the past decade. The fact is that both the supply and demand side of the fundamental equation for the energy commodity has undergone dramatic changes.

The discovery of massive reserves in the Marcellus and Utica shale regions of the United States and technological advances in hydraulic fracking has increased the supplies of natural gas at an exponential rate since the last time the price traded above the $10 per MMBtu level. At the same time, the cost of production has dropped because of both technology and, more recently, an energy-friendly administration in Washington DC that has cut regulations and decreased corporate tax rates. The lower price over recent years is the result of considerable increases in supplies at a lower cost.

Necessity is the mother of invention, according to the Greek philosopher Plato, and in the natural gas market increased supplies have resulted in more uses for the energy commodity. Today, electricity in the U.S. has moved from coal-fired to natural gas-fired generation which has resulted in an increase in the demand side of the fundamental equation. Most recently, processing the energy commodity from its physical form into liquid for exportation around the world has expanded the addressable market for natural gas beyond the forty-eight states and countries that share borders with the United States. Ocean tankers filled with LNG or liquid natural gas now travel around the world to areas where the energy commodity is not readily extractable from the crust of the earth and where it trades at a higher price. It is likely that the increase in open interest at a time when the price range has declined is a reflection of the overall expansion of the market for the energy commodity. However, as it approaches an all-time peak, the metric could be signaling that speculative interest as increased over recent weeks as it has moved from 1.422 million contracts on May 1 to 1.557 million, a rise of 9.5% as the price has trended slightly higher over the period. The increase in open interest could be a sign of growing upside price pressure in the natural gas futures market.

Trade the range

Until natural gas finds a way to break above $3.01 or below $2.70, it is likely to remain in the current trading range. For those of us who cannot live without a position in the natural gas futures market, the triple-leveraged bullish UGAZ and bearish DGAZ ETN products offer a way to magnify trading results on relatively small price moves. UGAZ trades an average of 1.8 million shares each day while DGAZ's average is 3.8 million shares. These two leveraged and highly successful ETN products are only for short-term trading, as their gearing causes them to decay dramatically over time. UGAZ was trading at the $62.50 level on Friday, while DGAZ was at around $24 per share. The price differential between the bullish and bearish products is the reason for the difference in average daily volume. The routine reverse splits in the triple-leveraged ETN products changes the volume metrics which adjust to the price of the shares.

UGAZ and DGAZ long positions pepper the portfolios of many market participants because of the decay factor. Therefore, positions in these instruments should never remain in one's possession longer than one week as the chance of them reverting to dust collector status increases dramatically with time.

I will continue to trade the tight range in the natural gas futures market until I get stopped out above $3.05 or below $2.65 per MMBtu. I have had success over recent weeks using this strategy, but given the volatile history of the energy commodity, I am always prepared for a surprise that will cost me money.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.