On any recovery strategy the energy complex needs to be a significant component of a portfolio.

While oil offers substantial promise of further price gains in the medium and long term we would ideally like to see prices reset towards the 57.5 dollars a barrel, a level which would more efficiently protect against tactical corrective risk and allow a safer positioning for a challenge to the current barrier set at 77-78. Once this level is overwhelmed – a question of when not if- oil prices can be expected to proceed towards 90 and in the longer term reach a clear target at 120.

Natural gas however currently profiles a unique opportunity for investment in the energy complex, whose potential far exceeds that seen in oil.

While crude oil prices bottomed in mid-February at 33.5 dollars a barrel and more then doubled since (a strong barrier from 73 to 77 has been containing prices since June), the price of natural gas has continued to fall.

Natural gas prices peaked at 13.65 at the beginning of July 2008 and fell precipitously to 3.1 at the end of last April. The still bearish consolidation that extended from May to July has given way to a heavy retreat that took prices down a further 40% from early August as prices plunged from 4 dollars per MBTU to just under 2.5 dollars at the time of writing.

The reasons for the recent dive in natural gas prices are twofold.

North American producers have been keeping output at full capacity in recent months leading stocked inventories far above the average of the last 5 years even as demand contracted in a normal seasonal manner. The pressure on prices has been the inevitable result.

A concomitant negative factor is rooted in intense buying by investors from the time when oil turned up in last February. High cash levels in investor’s portfolios favored a spree of buying in shares of existing Natural Gas ETFs (Exchange Traded Funds) which in turn led to purchases of natural gas futures on the Nymex and in shares of quoted exploration and production operators and companies servicing the industry.
A regulatory rumor that the CFTC would regulate ETFs’s offering of new shares in order to limit the surge in demand (by natural gas ETFs) for futures contracts on the Nymex led the leading ETFs to voluntarily suspend the emission of new shares, thus virtually turning them, at least temporarily, into closed end funds. This reaction from the ETFs to the rumors of regulatory action has led to the almost immediate opening of a substantial premium in the price of natural gas ETF shares to Net Asset Value, even as the NAV plunged as a result of reduced demand.

Substantial losses on futures contracts led to forced liquidation which precipitated and basically drove the 40% collapse in prices seen since early August.

As the squeeze generated by this special situation plays itself out, we are nearing a point where prices will reach a bottom and the trend in natural gas prices will be again conducted by fundamentals and market expectations.

To summarize the developments so far: the de-linking of oil and natural gas prices since last winter has been caused and must be clearly understood at two levels:

-First, by the glutting of the market (as operators produced flat out at full capacity) leading inventories to surge far above normal levels. This has been responsible for the lack of response in natural gas prices to the upturn in oil seen since last winter. While OPEC volume cuts hit the market natural gas output continued at full capacity.

-Second, the special situation that arose this summer in Natural Gas ETFs (see above) broke the surge of new money and combined with the plentiful supply situation has rapidly induced massive forced liquidation on the futures market. Prices plunged by 40% in six weeks.

Once the current situation is understood the next step needs to be an attempt to present a structured view of the outlook for Natural Gas prices which will allow the outlining of an investment strategy.

In order to consider a bullish strategy for Natural Gas portfolio investment one needs to set the background first.

Our view is that economic recovery is under way, in its early stages, and the cyclical upswing emerging has the potential to offer a remarkable stage for economic growth in coming years. (See our paper ‘Bears can miss a remarkable recovery’ published on September 1st 2009). We believe that, contrary to prevailing market, views this recovery has staying power and a very considerable potential. Moreover, for the first time, the economic upswing will be synchronous and global, thus offering exceptional scope for dynamic synergies in demand.

Energy demand for non-renewable sources has a positive outlook in the mature developed markets from the second half of 2009 but it’s from the momentum of recovery in the major Emerging Markets (China in front) that the volume in demand and consumption will derive its major strength.

Cartelization of production (with OPEC producing 40% of output and monopolizing swing capacity in production) in the face of a resumption of rising consumption of oil, along with underlying concerns about exposure to risks in the security of supply will lead to oil prices resuming a pattern of increases that substantially exceeds the nominal increase in world demand. Barring a collapse in the discipline of the cartel or an unforeseen relapse in the world’s emerging recovery the outlook for oil is bullish (see the second paragraph of this paper for price targets).

Natural gas prices have correlated with oil prices over the long term. The ratio of crude oil prices to natural gas prices has in recent years oscillated between 15x (cheap gas) to 8x (expensive gas). A ratio straying from this range has only been seen briefly at the end of 2008 with a temporary reading of 7x indicating that Natural gas was particularly exposed relative to oil.

Natural gas started a supertrend of cheapening relative to oil since the end of 2008, the determinants of which have been pointedly analyzed above. The range of the indicated ratio has dramatically strayed to the upside to stand at 27x at the time of writing.

There is no way of ascertaining, with a satisfactory degree of security, what the elasticity of this swing will be, in other words how much cheaper can natural gas prices move relative to oil. However if statistical measure can be any guide useful indications can be drawn.

We have tested several variables and found a meaningful fit in the oscillator (value difference) of the moving average of 36 days to the one for 55 days. This statistical measure of elasticity should be entering peak levels from mid-September. At that point the spread will not be sustainable and a reset to lower levels for the ratio will be seen, indicating that natural gas prices will tend to move up relative to oil anytime from mid-September to mid-October.

For additional statistical security we have added a comparison of the ratio to its 50 day moving average.
As the oscillator, this measure has correctly revealed the cheapening of oil relative to natural gas since September 2008 to January 2009. At that point in time, natural gas prices were unsustainably expensive relative to oil prices and the premises of the above mentioned decoupling that led to the extraordinary fall in natural gas prices where clear to see.
Since then the fall of natural gas prices relative to oil has moved dramatically above historical norm and currently stands at the equally unsustainable levels of 27x and the ratio has stayed consistently above its 50 day moving average since January. If the spread values of the oscillator are any guide, a peak should be found in the next 2-6 weeks.

Provided eventual tactical corrective pressure on oil prices maintains levels above 57.5 dollars a barrel, the best prognosis for the timing of entering a long Natural Gas position on the Nymex futures market will be seen between mid-September and mid-October.

Moving away from correlation analysis and focusing on the price of natural gas our non-linear (cyclical) extrapolation instruments also indicate an imminent bottom to the retreat in gas prices with potential bearish target limits at 2.35 dollars per MBTU or eventually (under more extreme assumptions) the area of 1.8 dollars per MBTU.

When the trend bottoms for natural gas prices the ensuing rise will hit minimum targets of around 5 dollars ( a 100% gain from current extreme levels) and subsequently 6.5-6.75 dollars within 12 months of the turn.
Long term price targets can approach 11 within an estimated time frame of 36 months.

For those to whom quantitative analysis needs convincing background of fundamental factors we may add that storage capacity in the United States will reach its physical limits (at current output levels) in October, thereafter forcing production to be curtailed. Demand, on the other hand will start to increase from November on seasonal grounds.

N.B.:The present paper is not an invitation or solicitation to purchase assets analyzed above, and the author, an independent consultant, in no way benefits from transaction fees or any other form of compensation other than that that may derive from its own decisions.

Antonio Ferreira
September 4th 2009