Are Capitulation Lows Buying Opportunities?

My reports focus on Natural Gas rates because it is now the largest source of energy for the generation of Electricity in many regions; therefore, Natural Gas and Electricity rates are highly correlated.

In my Oct 7^th report, I said we would likely experience a short covering rally into November, but as you can see in the chart below the rally did not materialize and the nearby contract plunged to a possible capitulation low of $1.948 per MMbtu the day before expiration on Oct 27^th.

As you can see in the above chart, Natural Gas traded in a very tight trading range in 2015 until recently. When a market trades in a very tight trading range it is because a battle is being fought between those who believe prices will rise due to bullish factors and those who believe prices will decline due to bearish factors. In last month’s report I stated after testing this year’s spring low in early October the seasonal tendency favored rates rising in October as the market anticipated increased demand in the winter heating season.

But this year, based on the following, Natural Gas ignored this tendency and focused totally on the following 4 bearish factors:

1. We are on pace to start the winter heating season with a record amount of Natural Gas in storage. Last Thursday, the EIA announced storage levels stood at 3,877 trillion cubic feet, and we will likely surpass the all-time high of 3,929 trillion cubic feet reached in November 2012 later this month.

2. The belief production will continue to increase due primarily in the large reserves of Natural Gas in the Marcellus and Utica shale regions.

3. The belief demand will not be strong this winter because NOAA is forecasting a 95% probability a strong El Nino will occur this winter, which historically is associated with cooler and wetter than normal winters for the Southwest and Southeast, but drier and warmer winters for the high usage energy users in the Midwest and Northeast.

4. The proverbial straw that broke the camel’s back may have taken place In the middle of October, when NOAA forecasted milder than normal weather for a large portion of the United States for the following 30 days, and this news in conjunction with the first 3 factors gave short traders the upper hand, and rates collapsed heading into the expiration of the nearby contract on October 28^th.

The above factors all contributed to Natural Gas breaking out of the very tight trading range from $2.40 to $3.00 per MMbtu it was entrenched in 2015 and tumbled to $1.948 per MMbtu in 4 trading days. I titled this month’s report, “Are Capitulation Lows Buying Opportunities?”

This report will attempt to answer the following questions:

1. Are capitulation lows buying opportunities?
2. Is Natural Gas a good buying opportunity at present price levels?
3. What bullish factors support higher prices?

Before answering these questions we first need to understand what it means to have a capitulation low in a market. Capitulation lows are reached when investors simply give up. This happens when investors either no longer believe in their position or in some instances are forced to sell because their contract is about to expire. I believe the Natural Gas low of $1.948 per MMbtu the day before expiration on Oct 27^th was the result of both factors coming into play.

Over the years as a trader I looked for capitulation selling in any market, and when it occurred I considered it a great entry point. When buyers give up and a market goes into a freefall, it is capable of reaching price levels below what can be sustained over time. Therefore, the answer to the first question is I absolutely believe capitulation lows are excellent buying opportunities.

The next question is Natural Gas a good buying opportunity at present price levels?

The answer can be found by exploring further what triggered Natural Gas capitulation low on Oct 27^th. Buyers of Natural Gas gave up hope based on the 4 factors listed above, and Natural Gas again started to decline in the middle of October triggered by the 4^th factor when NOAA forecasted milder than normal weather for 30 days. The selloff accelerated after the spring low was pierced on October 22^nd, and buyers were forced to sell their losing positions with the nearby contract plunging to $1.948 per MMbtu the day before expiration on Oct 27^th.

As I previously stated capitulation lows lead to price levels unsustainable over time. This is where I believe we find ourselves presently with Natural trading near a 15 year low.

Below is a 15 year chart of Natural Gas.

As you can see in the above chart, not only did Natural Gas test the Spring 2012 low of $1.902 per MMbtu, it approached the Fall 2001 low of $1.76 per MMbtu.

If you look closely at the chart you will notice 99% of the time Natural Gas has been higher than $2.00 per MMbtu; therefore, although if we experience a warmer than normal winter Natural Gas could test the 15 year low near $1.76 per MMbtu, but if it does, it will not be a sustainable price, and would lead to an even more explosive rally.

The last question is what bullish factors support higher prices?

To answer this last question let’s first look more closely at the 4 bearish factors that contributed to the plunge in Natural Gas prices along with 2 other factors.

1. Although it is true we are on track to marginally surpass the all-time high of 3.929 trillion cubic feet reached in November 2012 later this month, the new record will not be significant historically. You will have a better understanding of why I say this by looking at the chart below.

If you look closely at the chart above, you will notice Natural Gas prices increased after reaching the all-time high of 3.929 trillion cubic feet in November 2012. It is important to note, the winter of 2012/13 was not a cold winter and Natural Gas prices still increased. Starting this winter with marginally higher supplies does not guarantee Natural Gas prices will decrease from present levels.

2. Although it is true production will continue to increase primarily due in the large reserves in the Marcellus and Utica shale regions, the increases will be tempered by decreases in many other regions, which are suffering from depletion of reserves and decreases from unprofitable wells that have been capped or shut down.

3. Although it is true NOAA is forecasting a 95% probability a strong El Nino will occur this winter, all El Ninos are not the same. In the winter of 1972/73 we experienced a strong El Nino, but we burned much more Natural Gas than normal. El Ninos are characterized by severe extremes in regions and it is impossible to know with certainty the net effect on demand for Natural Gas this winter.

4. Although it is true we are experiencing very mild fall season thus far, which as I said earlier was the straw that broke the camel’s back leading to the collapse in Natural Gas, you may recall last year we experienced a brutally cold November followed by a milder than expected winter. Could this year’s warm November portend a colder than expected winter?

5. In last month’s report, I stated a retest of the spring 2012 low would be long-term very bullish for Natural Gas and subsequently Electricity. The boom in drilling based on new fracking technology has been funded largely with debt, which many drillers are now struggling to pay due to low cash flow from low prices. A sustained drop below present rates will challenge the survival of many drillers and production levels will be adversely effected.

6. Hydraulic fracking has led to lower prices, but lower prices along with the closure of coal fired plants has substantially increased demand, which is supportive to higher prices. The ongoing struggle between increased production and demand will invariably lead to increased volatility. This is primarily due to the limited storage capacity of natural gas, which will lead to wild swings in prices when either supply or demand gains the upper hand.

In summary, I believe the recent collapse in Natural Gas is an excellent opportunity to enter new hedges and extend hedges already in place. I believe the bearish factors discussed in this report are already factored into the price of Natural Gas, and based on the bullish factors discussed in this report today’s low pricing will be short lived and will usher in much higher pricing in the years to come.

Not every client’s risk tolerance and hedging strategy is the same, but we trust the above report will help you put into perspective the risk/reward opportunities at this time. I invite you to call one of our energy analysts to help you plan a hedging strategy appropriate for your situation.

Ray Franklin
Senior Commodity Analyst                                                                                          
727-400-3170