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What is Up with Natural Gas?

(December 17, 2006)

Dear Subscribers and Readers,

As we approach Christmas and the New Year's holidays, I hope that many of you will have time to reflect on what you have done or achieved over the past year – whether those achievements are in your personal life, your career, or your realm of investment knowledge.  As I have mentioned or implied over the last couple of weeks, I am doing exactly that, as I am currently in Houston for some rest, relaxation, and reflections.  Since next Sunday will be Christmas Eve, I am planning to only write an “ad hoc” commentary once again for our subscribers.  While there may not be any charts in that “ad hoc” commentary, I promise that there will not be a lack of substance.  Mr. Rick Konrad from the excellent investment blog Value Discipline will be again writing for us this Thursday morning.  I will then come back with my very own preview of the major important themes for 2007 next Thursday morning (December 28th).

Before we continue with our commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,060.52 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 940.52 points

Our first signal has given us a gain of over 1,000 points – and while many newsletter writers will relish in such a “feat” (especially in light of this difficult year), we are definitely not being complacent at this point.  The current rally that effectively began in mid-August is now “long in the tooth” – at least relative to the magnitude, length, and breadth of the many rallies we have had since January 2004.  However, subscribers should continue to keep in mind that the four months ending August 2006 represented a period of capitulation at least among retail investors – as exemplified by the highest mutual fund outflows for that period since the four months ending October 2002.  Make no mistake: A rally off such a significant bottom will usually not end until exhaustion – and we are still not close to such a point yet.

As of Sunday afternoon on December 17th, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot (which is now also expanding in China), Microsoft, eBay, Intel, GE, and American Express. We are also bullish on both Yahoo, Amazon, and most other retailers as this author believes that “the death of the U.S. consumer” has been way overblown.  We are also very bullish on good-quality, growth stocks.  In the very short-run, the market still has enough strength to rally until the end of this year, and possibly into early to mid January if we do not have a significant correction in the meantime.  Based on current sentiment and breadth, there is a good chance we will not see a significant correction (meaning 5% or more) in the major stock market indices until the DJIA approaches the 13,000 level or the S&P the 1,500 level.

In last weekend's commentary, I gave a quick update of U.S. household finances as of the end of the third quarter 2006.  In that commentary, I discussed the relatively low holdings of equities (especially domestic equities although we do not have reliable statistics of how much international equities U.S. households are holding) of U.S. households as a percentage of both total and financial assets.  While the bears will “relish” in the fact that the asset-to-liability ratio of U.S. households has continued to decline over the last 54 years, it is imperative to keep in mind that an asset-to-liability ratio of 5.2 is still very manageable – especially in today's low interest ratio environment and the easy availability of consumer credit.  In light of the Bank of England's study that we discussed last Thursday, however, the $64 trillion question to ask is this: How are assets of households' private businesses taken into account in the Federal Reserve's Flow of Funds data?  This has special importance – especially over the last two decades as U.S. households have continued to be more entrepreneurial in nature.  While holdings of publicly-traded equities, bonds, and cash are very easily valued, it is very difficult to value private businesses even if the Federal Reserve has in its possession all the income tax returns of private businesses in the U.S.  Assuming that it does (and assuming that the IRS has perfect records), however, it is highly doubtful to this author that the Fed is valuing U.S. private businesses at anything other than book value – a measure which is too conservative by any stretch of the imagination.  Assuming that this is true, and assuming a price-to-book ratio of 2 is appropriate (which is slightly over 10% less than the P/B ratio of the S&P 600) – then there is a good chance that the Federal Reserve is valuing U.S. private businesses at half of their true worth (or even less for businesses that are not capital or real estate intensive, such as MarketThoughts.com!).  If that is the case, then according to the latest Flow of Funds data, U.S. household assets may be undervalued by more than $7 trillion – or just slightly over half of all U.S. household liabilities.

Okay, so much for another “rosy analysis” on U.S. household finances.  Subscribers are probably getting tired of this already.  Let us now get to the gist of our commentary and discuss a commodity that was the first to top out in the latest cyclical bull market for commodities – that being, natural gas.

We first discussed natural gas in detail in our July 31, 2005 commentary (“Natural Gas – the Other Bull?”).  In that commentary, we discussed the fact that natural gas production has been steadily declining in the lower 48 states of the US, despite the fact that rig count had increased 80% since 1997.  More ominously, this situation could also be directly applied to Canadian production (which supplies nearly 20% of all US consumption).  Quoting a National Energy Board December 2004 report: “[the] effective decline rate for production from existing wells is expected to remain at around 21% per year.  This means that new connections would need to replace over a fifth of the previous year's output to keep overall production constant."  Moreover, the "trend of lower initial productivity in new WCSB gas wells [the Western Canada Sedimentary Basin - which currently accounts for 98% of total Canadian production] is continuing.  Consequently, to offset production declines from producing wells, the number of new gas connections must rise each year to maintain production levels.  The Board expects that the number of gas wells drilled would need to increase from 15,100 in 2003 to about 15,600 in 2004, and 17,900 by 2006 in order to maintain current production  In other words – according to the Canadian government's National Energy Board at the time, Canadian production most probably was near a peak as well.

In that commentary, we also discussed the relatively high correlation of natural gas prices vs. crude oil prices (the historical “6-to-1 ratio” on an MMBtu/barrel basis).  I concluded that given this declining supply, this high correlation, and the high tendency for natural gas price spikes (natural gas has historically been three times more volatile than oil prices), then there was also a good chance natural gas prices would spike higher sooner than later.  Quoting from our July 31, 2005 commentary: “In a high demand (unusually cold weather) environment and assuming that oil prices stay at $60 a barrel during the winter, I would not be surprised to see a "sustainable" natural gas price of $15 to $17/MMBtu somewhere during that timeframe (assuming this historical relationship holds).”  By a sheer stroke of fortune, natural gas prices did indeed touch these levels very soon after the publication of our commentary – with the one-two punch of Hurricanes Katrina and Rita, and with the subsequent colder-than-expected winter in early to mid December 2005.

Most recently, however, natural gas prices have steadily increased and then plunged during the August to September 2006 period.  The following chart showing the prices of the January 2007 natural gas futures contract illustrates this bear market in natural gas perfectly:

Prices of the January 2007 natural gas futures contract

Moreover, the historical “6-to-1” relationship” with crude oil prices has broken down recently, as illustrated by the following chart showing month-end crude oil spot prices vs. month-end natural gas spot prices at the Henry Hub from November 1993 to December 2006 (with the December 2006 month-end prices estimated using the December 15, 2006 closing prices):

Month-End Henry Hub Natural Gas vs. WTI Crude Oil Spot Prices (November 1993 to December 2006*) - 1) Historically, natural gas prices have pretty much tracked crude oil prices here in the United States. More importantly, the historical volatility in natural gas prices is far greater than that of crude oil (as noted by the wider movements in natural gas prices and by the three upside spikes at the end of December 2000, February 2003, and September 2005). At the end of July of last year, I stated: *Given the wide variations in weather patterns in recent years and give the tight supply situation, I think we are overdue for another such spike.* Given the underperformance of natural gas over the last few months, and given that winter is now upon us, are we now overdue for another spike in natural gas prices? 2) Natural gas prices again lagging despite the fact that winter is now upon us!

So what is up with natural gas?  Hasn't North American supply peaked?  Isn't LNG supply from countries such as Albania and Russia still at a trickle?  Aren't we consuming natural gas at an ever-increasing rate?  All these are worthwhile questions.  This author believes that the weakness in natural gas prices is due to the following three main factors:

1. Good old demand destruction as a response to a surge in natural gas prices from Fall 2005 to December 2005.  Not only did many industrial users resort to “fuel-switching” (switching from consuming natural gas to oil) during this surge in natural gas prices in late 2005, many industrial users actually closed down or relocated their businesses overseas in response to this higher cost.  Unlike demand destruction at the residential or commercial level, this demand destruction on the part of industrial users means that demand from this segment will never come back.  Moreover, the ability of many industrial users to shift between consuming oil to natural gas (and vice-versa) has historically played a significant role in determining the correlation between oil and natural gas.  Now that many industrial users have been removed from the equation, there is a good possibility that this historical “6-to-1” relationship has now effectively broken down.

2. Much of the spike in natural gas prices during late November to early December 2005 was due to a speculative shift into the commodity by hedge funds (the natural gas market is significantly less liquid than the crude oil market and is thus more easily subjected to “manipulation”).  At the time – despite the fact that the early winter was colder than usual – supply was still ample.  However, everyone and his neighbor were merely extrapolating the temperatures in early December 2005 into January and February 2006.  In retrospect, both the months of January and February 2006 were warmer-than-usual.  As the hedge funds exited the commodity, natural gas prices subsequently plunged over the next couple of months.  After this price spike, natural gas no longer attracted any new money from hedge funds.  The liquidation of the hedge fund Amaranth was the final straw – as its collapse resulted in a crash in natural gas prices as the fund exited from its long positions in natural gas.

3. Storage levels remain ample – as current natural gas storage levels is 8% higher than its five-year average and 7.5% higher than storage levels at this time last year.  Not only does this signal that overall demand has actually decreased (mostly because of the decline in industrial demand), but that the market is well supplied as well.  In that light, we turn to the EIA's U.S. Crude Oil, Natural Gas, and Natural Gas Liquids Reserves 2005 annual report, which was just released last month.  According to the EIA, natural gas reserves at the end of 2005 increased 6.2% from the end of 2004.  Quoting the EIA's report: “Reserves additions replaced 164 percent of 2005 dry gas production as U.S. gas reserves increased for the seventh year in a row. Proved reserves of natural gas increased by 6 percent in 2005, the largest annual increase in natural gas proved reserves since 1970.”  More importantly, total discoveries of natural gas reserves were 23.2 Tcf in 2005 – which was 45% more than the prior ten-year average and 15% more than in 2004.  In other words, all those new drilling actually was quite effective (higher prices didn't hurt either) – contrary to our views in our July 31, 2005 commentary.  Following is a chart showing U.S. natural gas reserves as documented by the EIA from 1995 to 2005:

U.S. natural gas reserves as documented by the EIA from 1995 to 2005

Please note that natural gas reserves have increased every year with the exception of 1998.  More interestingly, note that onshore reserves have actually steadily increased while offshore reserves have steadily decreased during the last ten years!  In other words, while there has been ample drilling in the Gulf of Mexico, this is not necessarily the case in deeper offshore waters or in other parts of offshore United States.  If push comes to shove, this suggests that domestic natural gas reserves can continue to steadily climb for the rest of this decade should the U.S. choose to drill for natural gas in deeper waters or in other parts of offshore United States.

Conclusion on natural gas: While it is tempting to place a bullish bet on natural gas prices based on the historical correlation between oil and natural gas prices, this author believes there is now a good chance that this historical relationship has now broken down – suggesting that natural gas prices do not have to increase from current levels.  More importantly – given the fact that natural gas reserves have continued to steadily increase and the fact that natural gas storage levels remain at the high end of its five-year average – there is a good chance that natural gas prices (especially in the summer contract months) are still very vulnerable to further price declines going forward.  Until there is another boom in the construction of natural-gas fired electricity generators (which probably will not happen again until natural gas plunges to the $5.00/MMBtu level and stay there for a whole year) this author will not suggest buying either natural gas futures or natural gas producers and holding them for the long-run.

Let us now shift back to the U.S. stock market and discuss the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from October 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to December 15, 2006) - 1) After over six years, the Dow Industrials has finally surpassed its all-time high (on October 3, 2006) of 11,722.98 made on January 14, 2000, while the Dow Transports surpassed its all-time high of 3,783.50 (made on May 12, 1999) way back in December 2004. 2) For the week ending December 15, 2006, the Dow Industrials rose 138.04 points while the Dow Transports declined 19.11 points. Since the mid November highs, the Dow Transports has been the weaker Dow index, and the action over the latest week is no different (this divergence over the last month is probably the most notable since October 2004). Moreover, since the Dow Transports has been the leading index in this bull market since October 2002, the recent underperformance is definitely a red flag. For now, however, readers who are long should continue to hold - as I believe that both of these indices are still in intermediate uptrends. However, should the Dow Transports get weaker, then it may be time to start cutting your positions.

For the week ending December 15, 2006, the Dow Industrials rose 138.04 points while the Dow Transports declined 19.11 points.  As mentioned on the above chart, the Dow Transports is definitely the weaker index – and this weakness in the Dow Transports is now bothering me.  For now, however, the intermediate uptrend remains intact – especially given the historical tendency for the market to rise at the end of the year (one reason is the fact that both IPOs and secondary offerings are now effectively non-existent).  Also, unless the Dow Transports decline below its November 3rd low of 4,612.69 (we are currently 88 points away), however, there is still no cause for alarm just yet.  We continue to remain 100% long in our DJIA Timing System, given that the intermediate trend remains up and given that we expect the Dow Industrials to reach a higher level by the end of this year than the level it closed at last Friday.  Readers please stay tuned.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators bounced from an extremely oversold level of 1.7% in late June to 26.0% for the week ending December 15, 2006.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending December 15, 2006, the four-week MA of the combined Bulls-Bears% Differentials declined from 27.0% to 26.0%. The fact that this indicator is still overbought and trending down suggests that the market is still very vulnerable to a correction - but the bottom line is that the intermediate trend still remains up for now.

As mentioned on the above chart, the four-week MA of this indicator has been effectively rising non-stop since early August – although it did managed to dip slightly over the last few weeks.  While this reading is still overbought, this author would not be surprised to see the market move higher over the next couple of weeks given the historical tendency for the market to rise at the end of the year.  Moreover, the Rydex Cash Flow Ratio (currently at 0.83) is still suggesting that we are nowhere near close to “exhaustion.”  In other words, the potential for a further rise in the stock market over the next couple of weeks is very much in place.  Following is a daily chart of the Rydex Cash Flow Ratio vs. the S&P 500, courtesy of Decisionpoint.com:

Rydex Cash Flow Ratio vs. the S&P 500

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

ISEE Sentiment vs. S&P 500 (October 28, 2002 to Present) - After rising relentlessly from late September to mid November, the 20 DMA of the ISEE Sentiment has finally pulled back and was again essentially flat over the last two weeks - rising from 137.2 to 138.0. Moreover, the 50 DMA has caught up - and for the first time since October 9, the 50 DMA is actually above the 20 DMA. This is definitely a well-needed *rest,* and suggests that stocks should continued to be purchase *on the dips* in general.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment has been rising relentlessly since late September (bottoming at 101.5) until the middle of last month – topping out at 146.5.  Since then, it has retraced some of its rise – and is now sitting at 138.0, slightly up from a reading of 137.2 on December 8th.  Meanwhile the 50-day moving average is still rising, coming in at a reading of 139.3 as of the close last Friday.  The latest pullback in the 20-day moving average was definitely a well-needed rest for bullish sentiment and given that the 50-day moving average has not only caught up with the 20-day moving average and but has now surpassed it, this suggests that there is a good chance the stock market will continue to rise over the next couple of weeks.

Conclusion: Given the decline of natural gas prices over the last 12 months, and given its historical correlation with crude oil prices, it is certainly very tempting to go long natural gas or natural gas producers at current levels.  Based on the latest reserves and storage data from the EIA, however, there is a good possibility that natural gas prices have not bottomed out yet.  More importantly, the historical correlation and the “6-to-1” relationship between natural gas and oil prices appears to have broken down – given that many industrial users (who had the capability to “fuel switch” between natural gas and oil) have now left the scene.  Bottom line: Until or unless the price of natural gas decline another $1 to $2/MMBtu all across the futures curve, this author would not even consider buying natural gas yet.

As for the U.S. stock market, there is a good chance that we will see a continued rise in stocks over the next couple of weeks, as both the number and amount of IPOs and secondary offerings should become muted as we approach the end of the year.  For now, I will give the benefit of the doubt to the Dow Transports, but should it decline below the November 3rd low of 4,612.69, then it is time to sit up and take notice.  For now, the intermediate term trend remains up – as we are nowhere close to any kind of exhaustion yet.  Again, we remain 100% long in our DJIA Timing System and do not intend to shift to a less bullish stance for now.

Signing off,

Henry To, CFA

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