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What about Natural Gas?

(August 20, 2009)

Dear Subscribers and Readers,

Since early March, the Dow Industrials and the Dow Transports have risen 42% and 70%, respectively.  Aside from the brief two-month consolidation period from early May to early July, the rally in both the US and global equity markets have been impressive – not only because of the magnitude of the rally but also because of the impressive upside breadth and volume.  Over the last three weeks, however, most of the world's major indices have moved nowhere.  More ominously, there are now strong signs that the Chinese stock market (the Shanghai Composite Index) has made an intermediate term peak, for the following reasons:

  1. At its peak earlier this month, the Shanghai Composite had almost doubled on a year-to-date basis, compared to a 7% YTD appreciation in the Dow Industrials and the Dow Transports, and a relatively “tame” 50% rally in the MSCI Emerging Markets Index.  In other words, the Chinese stock market had gone parabolic.  From the beginning of May to the end of July, the Shanghai Composite rallied more than 34% - equivalent to an annualized return of 223%!

  2. The strength in the Chinese stock market and the Chinese economy – coming in the face of a slowdown in general global risk-taking – could be classified as a negative divergence.  This is not dissimilar to the immense divergence in the prices of global technology stocks in 1999 relative to the prices of the “old economy” stocks or small cap value stocks.  In other words, liquidity is still challenged – but what little is there is going into the “momentum play” that has been working, and the Chinese stock market has definitely been a great momentum play in 2009.

  3. More importantly – unlike when the correction began early this month – the Chinese government “put” has gone away, i.e. neither the People's Bank of China nor the Chinese government is trying to “jaw-bone” the market back to its former heights.  With the OECD leading indicators now decidedly rising, it seems like the Chinese authorities are content to “tap on the brake” on the Chinese economy by curbing speculation on the equity market and cutting back bank lending (a significant chunk of which had gone into margin lending).

Historically, the Chinese stock market had neither been a good leading indicator of the Chinese economy nor of other global equity indices (unlike the U.S. stock market, for example).  Starting late last year, however, not only has the Chinese stock market been a good leading indicator of the Chinese economy, but the global equity market as well.  From a fundamental standpoint, this also makes sense, as the Chinese economy has been the sole driver of global economic growth over the last year.

At some point – once the US economy regains its footing – the Chinese equity market will no longer be as influential of a leading indicator as it has been over the last year.  In the meantime, its weakness over the last few weeks is definitely ominous.  At the very least, the strong rally in the Chinese equity market over the last year should lead to an extended consolidation period.  This scenario is now being confirmed by the most recent three-day action in the US stock market.  On Monday, both the NYSE and the NASDAQ Composite experienced a downside day as defined by Lowry.  For our readers who do not recall, a 90% downside day occurs when both the declining volume and the number of downside points equal or exceed 90% of the total volume and the total number of points, respectively.  A 90% downside day sometimes signals the beginning of a more serious decline, or if the market is already oversold, further evidence of a heavily oversold market.  A single 90% downside today like what occurred on Monday may create an oversold situation in the short-term – one that would signal a temporary bottom – but with a number of intermediate term indicators still neutral or in overbought levels, the chances of a sustainable bottom here is very low.  This weakness is also confirmed by the relative weakness in upside breadth and volume in the last two days – despite the seemingly recovery in the stock market.  As a result, Monday's 90% downside day could be a signal for a further correction over the next few weeks.  Should the market correct further over the next few weeks, my current support levels are around 8,700 for the Dow Industrials, 940 for the S&P 500, and 1860 for the Nasdaq Composite.

Since March, there has been immense strength not just in the global equity markets, but in many other asset classes as well, including commodities.  Unfortunately for UNG (the natural gas ETF) bulls, a similar rally hasn't occurred in the natural gas market, as evident from the following chart showing the month-end spot prices for natural gas vs. crude oil (from November 1993 to July 2009):

Month-End Henry Hub Natural Gas vs. WTI Crude Oil Spot Prices (November 1993 to July 2009) - 1) Historically, natural gas prices have pretty much tracked crude oil prices here in the United States. Moreover, 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). Given the underperformance of natural gas over the last six months, are we now overdue for another spike in natural gas prices? 2) Natural gas prices have been lagging crude oil prices since March!

Note that the weakness in natural gas prices are also evident on the entire forward curve, as exemplified by the sustained weakness (since March) in the January 2010 NYMEX natural gas contact.  Interestingly, at the same time, the natural gas ETF, UNG, has gotten so popular with retail investors that it is now trading at a 13% premium to its underlying NAV (the UNG isn't issuing any new units given the ongoing CFTC studies into curbing individual position limits on commodity contracts).  Note that the lag in natural gas prices relative to crude oil prices since March 2009 is actually unprecedented.

Of course, as I mentioned in an August 21, 2007 post on our discussion forum, the historical crude oil-natural gas price relationship has definitely broken down in recent years, given the decreasing influence of industrial consumers that have the ability to “fuel switch” between fuel oil and natural gas.  Another reason for the breakdown in this relationship is the increasing influence of Chinese economic activity on crude oil prices, while NYMEX natural gas prices are purely influenced by US domestic supply and demand (drilling, weather, GDP growth, etc.) activities.

With domestic natural gas storage levels at 592 BCF (billion cubic feet) over the five-year average (see below chart, courtesy of the EIA), it makes sense for natural gas prices to be trading at seven-year lows:

Domestic natural gas storage levels

On the other hand, both OECD and Chinese oil storage levels are also at all-time highs.  Moreover, the US economic leading indicators (from the OECD, ECRI, and the Conference Board) have been picking up in the last couple of months, suggesting a sustained increase in natural gas demand (weather-related fluctuations notwithstanding) is in store going into Thanksgiving and Christmas.  Moreover, according to RBS Sempra, there has been a noticeable production decline in natural gas in recent months, as indicated by pipeline data in Canada, the Rockies, and Waha, although this production decline hasn't translated into any decline in natural gas inventories just yet.

The economics of new well production (where the vast majority of the gas is produced within the first few years of the life of the well) suggests that the industry has to keep on drilling in order to sustain the amount of natural gas production in any given year.  And on this front, the news is also encouraging for the natural gas bulls, as the number of natural gas rig counts has been consistently decreasing since September 2008, as shown in the following chart courtesy of RBS Sempra and Baker Hughes:

Weekly U.S. Natural Gas Rig Count

While the short-term outlook for natural gas prices is still blurry, this author is getting more bullish on the longer-term (over 12 months) outlook.  Given the premium in the UNG ETF and the significant seasonal spread on natural gas future prices, I do not recommend a long position just yet (and probably won't for the foreseeable future unless the natural gas price curve drops another 10% across the board).  In the meantime, I will continue to keep track of natural gas and alert you should I decide to go long on the commodity.  Subscribers please stay tuned.

Signing off,

Henry To, CFA


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