Natural Gas Consolidation Harbinger of Increased Volatility?

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

In today’s report, I explain why Natural Gas prices have consolidated over the last 2 months and why it is a harbinger of increased volatility, and why I believe the upside risk far exceeds the downside reward potential.

1. Why have Natural Gas prices consolidated over the last 2 months and why it is a harbinger of increased volatility?

As you can see in the chart below, since June 1^st, Natural Gas has traded within a relatively tight trading range (consolidating) between $2.83 and $3.11 per MMbtu as the market attempts to digest 2 powerful opposing factors:

1. On the bullish side, the primary factor is increased LNG and Mexico exports have increased demand for U.S. Natural Gas. S. Natural Gas exports this week for the first time exceeded 7 Bcf/d, and export demand is expected to increase for years to come. Increased export demand has created structural supply/demand imbalances, which I discussed in my Feb 9^th, 2017 Energy Alert, and although the situation has improved slightly, it is not resolved. Production is increasing slowly, but with exports continuing to increase, supplies are expected to end this year’s injection season below the 5-year Moving Average; thereby limiting the downside risk of lower prices.
2. On the bearish side, the primary factor is fracking technology opened large deposits of Natural Gas reserves, and new infrastructure is coming on line to transport Natural Gas from the new reserves. The net result is Northeast production is producing at all-time highs, but many other U.S. shale basins production have decreased due to the depletion rate of older wells, which is limiting total U.S. production increases, thereby also limiting the risk of substantially lower prices.

The above bullish/bearish factors have caused battle lines to be drawn between those focused on increased export demand versus those focused on increased production due to fracking. Whenever 2 powerful opposing factors lead to a market consolidation, it invariably is followed by an explosive move in one direction or the other, as one side gains control of the market. The trigger in most cases is an unanticipated event causes one side to gain control and forces the other side to cover their positions.

The question is, which side will likely win the battle, the Bulls or the Bears?

1. I believe the Bulls will win the battle, and in this section, I explain why I believe the upside risk far exceeds the downside reward potential.

Starting with my March 7^th, 2016 Energy Alert, I said conditions supporting a major bottom in Natural Gas were in place, and although prices could go slightly lower in the near-term, it was highly likely the average price of Natural Gas would be significantly higher over the next 12, 24 & 36 months. I have also repeatedly pointed out the similarities between the spring lows of 2012 & 2016, and why the spring 2016 low would likely hold for years to come. In hindsight, my prediction has come to pass, and we are now nearly 16-months into the recovery from the Spring 2016 low.

In subsequent Energy Alerts, I pointed out when a market reaches a major bottom, most traders do not believe prices will continue higher; therefore, they hold off buying, hoping prices will again decline. But Bull Markets are unrelenting, and they don’t give traders a second chance to buy near the bottom.

Since reaching the Spring 2016 low at $1.61 per MMbtu, Natural Gas rallied to near $3.00 per MMbtu by the end of June 2016, and has not traded below $2.50 over the following 13-months, and based on the Bull Market tendency of trading higher in a sequence of higher highs and higher lows, Natural Gas will likely not decline below $2.50 prior to trading much higher than present pricing near $3.00 per MMbtu.

This is not surprising since markets are a forecasting mechanism, and after reaching an unsustainably low price, they begin to adjust until reaching an unsustainably higher price. This is especially true for Natural Gas, which historically is one of the most volatile markets traded, and as you can see in the chart below, this is exactly what took place after Natural Gas reached a major bottom in the spring of 2012:

After reaching a major bottom in the spring of 2012, Natural Gas continued to maintain a pattern of higher highs and higher lows, until it finally reached a major top during the extremely cold winter of 2013/2014, and then and only then as shown in red, did Natural Gas break the pattern of higher highs and higher lows, and move lower. This was classic trade action as markets tend to reach bottoms when news is most negative fundamentally, and tops when news is most supportive fundamentally.

The question is, are we continuing to follow a similar pattern now to what took place after the spring 2012 low? The chart below shows we are:

As you can see present trade action is amazingly like the trade action prior to the explosive rally of Natural Gas in the winter of 2013/14. Therefore, although past trade action does not guarantee future results, the remarkably similar patterns are worth noting.

Also, it is important to note, as I explained earlier, Natural Gas is consolidating near $3.00 per MMbtu, and the supply/demand and technical factors favor Natural Gas staying above $2.50 per MMbtu. Therefore, the downside reward potential is limited, and given the tendency of Bull Markets ending with explosive rallies based on news events, the upside risk is substantial. The trigger could be a much warmer end to the summer, a major hurricane disrupting supplies, a geopolitical event or like 2013/14, a colder than normal winter. It is not a question of whether there will be news in the future supporting Natural Gas prices, it is only a question of when.

Conclusions

We are likely near a period of high volatility, and based on the fundamental and technical factors discussed in this report, the downside reward potential is limited, while the upside risk is substantial. Therefore, if you have not already hedged your cost of Natural Gas and Electricity, and are risk averse, we recommend you do so soon.

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 now. I invite you to call one of our energy analysts to help you plan a hedging strategy appropriate for your situation.

Ray Franklin
North American Energy Advisory
Senior Commodity Analyst