NatGas Still Has Room For Further Upside, But Prepare To Exit At $3.40

Includes: UNG
by: Hard Assets Investor

By Amine Bouchentouf

Taking a cautiously long position on natural gas can create opportunity; beware of the $2.80 support level.

Since I recommended going long natural gas in late June through the United States Natural Gas Fund (NYSEARCA:UNG), the ETF is up almost 10 percent, outperforming many commodities during this time frame.

At the time, the rationale was fairly straightforward: Prices had reached such a low that they actually risked going negative. There was so much excess supply that producers were close to starting to paying customers to buy their natgas. While that wouldn't practically happen, the fact that some market analysts even started predicting negative prices meant the market had reached a bottom.

In addition, faced with historically and abysmally low prices, the industry banded together and decided it was going put in place measures that would stem this downward spiral. Many producers began to shut off production and kept natural gas off the market in order to stabilize prices. These concerted efforts worked, and natural gas prices rallied dramatically as a result.

Furthermore, natgas prices were (and arguably still are) at such historic lows that they began a trend of substitution, whereby electric power plants began switching from coal to the cheaper natural-gas alternative. This substitution created a new stream of revenue for natgas producers as electric power plants began ramping up their orders, spurred by the historically low prices.

What's Next?

Let's put this in perspective again. Despite the rally we saw in late June and throughout July, natural gas prices are still trading at historically low levels. Prices are currently trading near the $3.00/mmbtu range, and we may be seeing a further plateauing of prices before we get a clearer indication of things to come. What's certain is that natural gas prices will continue to fluctuate fairly aggressively. That's the nature of the beast.

That said, prices are biased toward the upside simply because they are trading at extremely low levels and there are several bullish factors at play.

Another critical factor we need to monitor closely is the weather. Agricultural traders and investors are already very familiar with the drought that's been wreaking havoc in the continental states. This massive and historic drought in the U.S., which we haven't seen since the 1950s, is having a dramatic impact on prices for all sorts of natural resources, least of which is natural gas. A lot of the volatility that's inherent to natgas is sometimes attributed to weather patterns. Indeed, natural gas prices react very directly and sometimes very violently to changes in the weather.

Indeed, one of the bullish factors that helped natgas stage a rally in July has been the weather. As the drought continues and as temperatures increase, so does demand for natural gas, as homes and businesses increase their consumption of air conditioning. And as discussed earlier, since natgas prices are so low, many utilities are switching from coal, which is boosting demand. To be sure, this hot weather won't last forever and winter is right around the corner. These favorable weather patterns are not going to keep pushing natgas prices higher forever.

Trading Strategy

Natural gas is a very volatile commodity because of seasonality, weather patterns, an active futures market and other factors. If you followed my advice from June 26, you're sitting on about 10 percent returns - not bad in a challenging market environment dominated by the Chinese slowdown, the European debt crisis and a general lack of confidence in the world's financial infrastructure.

Natural gas prices have retreated about 4 percent in the last few trading sessions, and I believe this presents a buying opportunity in the short term. Weather is going to play a significant role in pushing prices higher - at least up until September/October, when temperatures start dropping, and with it, demand for air conditioning. If you are currently long natural gas, build on your position and start unloading once prices hit $3.40/mmbtu and even $3.50/mmbtu.

You can still initiate a long position at these levels, but I would advise caution since the rally is not certain and may break down, especially in a scenario where producers start dumping more product onto the market (enticed by the higher prices).

Certainly, if we fall below $2.80/mmbtu, I would close the position, since that's a key support level that could lead to further price deterioration. The bottom line: You can still generate some returns in natural gas during the next few weeks by being cautiously long. However, if the market turns, don't think twice about closing your position quickly and moving on, since you could be facing some dramatic losses.

Disclosure: The author doesn't have any positions in the stocks mentioned.