Downside Breakout a Buying Opportunity?

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

In my Aug 5^th Energy Alert, I stated we were close to breaking out of a symmetric triangle pattern forming since the end of April. Based on the factors discussed in my reports over the last few months, I felt the breakout would likely be to the upside, but this type of pattern is resolved with a false breakout approximately 1/3 of the time, which sets up an even more explosive move in the opposite direction.

The chart below shows we in fact experienced a downside break of the symmetric triangle.

In my August 5^th report I stated if we experienced a downside breakout the decline would be sharp and quickly reversed; therefore I am surprised after breaking out of the symmetric triangle on Monday, August 17^th, the decline has been relatively small.

What are the implications of the relatively muted downside breakout of a formation that normally leads to larger moves?

To fully appreciate the implications of this relatively small decline we must understand the factors triggering the downside break. The first factor was a larger than expected Natural Gas build of 65 Bcf reported by the EIA in their August 13^th storage report, which triggered the downside break of the symmetric triangle during the week of August 17^th. The pressure on pricing was reinforced by 2 bearish EIA’s weekly storage reports released on August 20^th and 27^th announcing storage increased faster than the 5 year moving average. This news alone should have been enough to push rates down to test the April 27^th low of $2.443 per MMbtu.

But rates held up well especially considering another factor, which put downside pressure on commodity prices. As you are aware the financial markets declined sharply the last two weeks and capital exited not only financials, but also commodities. This type of broad-based decline occurs periodically and offers outstanding buying opportunities for seasoned traders. It is important to note Natural Gas’s performance over the last two weeks was impressive considering the extremely bearish combination of larger than expected builds in storage along with a sharp decline in the financial markets.

The question is where do we go from here?

One possible scenario is this week’s EIA storage report will reflect a lower than anticipated build in supplies and the financial markets will stabilize and start to trade higher. In this scenario, Natural Gas would likely rally from present levels based on the factors I have written about over the last few months.

But there is another scenario in which the EIA continues to report larger than expected storage and the financial markets continue to decline. In this scenario as you can see in the chart below Natural Gas could potentially test its April 27^th low near $2.443 per MMbtu.

As shown in the above chart we potentially could decline from present levels near $2.71 to near $2.443 per MMbtu. Considering the tenuous state of our financial markets this scenario is certainly possible. Over the last 100 years, 60% of the 20 largest percentage declines in the United States financial markets occurred in either September or October. Therefore, we are heading into a high risk period for our financial markets. But is it wise to delay hedging your cost of Natural Gas and Electricity?

The answer can be found by identifying the risk of not hedging at present price levels versus the potential reward of purchasing at a lower level. The chart below shows graphically the risk/reward of Natural Gas prices over the last four years.

The above chart shows the potential upside risk of testing the high reached during the cold winter of 2013/14 versus the reward potential of testing the low reached in April 2012 after the warmest winter in 100 years.

In my last report, I said the secular bear market bottom reached in the spring of 2012 would likely hold for years to come; therefore this scenario is not likely. A more likely scenario would be a test of the April 2015 low, but even in the unlikely event we retest the April 2012 low the Risk/Reward ratio based on today’s pricing is 4.75 to 1. As an advisor anytime the Risk/Reward ratio is this highly skewed to the upside, I always recommend hedging your cost of Natural Gas and Electricity.

Remember as I wrote in my last report, the purpose of hedging your cost of Natural Gas and Electricity is to reduce risk, while the role of speculators is to assume the risk hedgers are unwilling to be exposed to. Speculators have the luxury of trying to catch the exact bottom because if they miss the bottom all it costs them is opportunity cost, and opportunity cost is not as expensive as lost capital. But hedgers don’t have the luxury of trying to catch the exact bottom because if a hedger misses the exact bottom it always results in lost capital.

But with that being said, if you are bottom fishing, which can be hazardous to your wealth, and we experience a broad based decline due to the collapse of the financial markets in either September or October hopefully you will not hesitate to take advantage of the opportunity.

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