Nearing a Short Covering Rally?

In my February 5th Energy Alert I said from an historical perspective rates are very low. If you have not read this report I encourage you to do so prior to reading this month’s report.

In this report, I will discuss why I believe we are nearing a short covering rally, which will last approximately 3 months.

What would lead me to this conclusion?

As I said in last month’s report, Commercial Hedgers are risk averse; therefore, when rates are low from an historical perspective they build their long positions. Is there evidence this is taking place at this time? Below is chart of Natural Gas prices for the last 6 years, which not only shows Commercial Hedgers ownership is approaching record levels of long positions, but also gives strong evidence we are nearing a short covering rally.

In the above chart, note there were 4 previous instances shown by the green arrows rising from the green line when Commercial Hedgers owned nearly 200,000 long positions. At the present time, Commercial Hedgers own more than 200,000 long positions.

What are the ramifications of this fact?

Unlike the stock market, the commodity market is a zero sum game, which means for every long position there must be a corresponding short position. Therefore, if Commercial Hedgers own more than 200,000 long positions, then someone must own the other side of the trade. As you can see in the above chart, Large Traders (speculators) as shown by the red line own over 200,000 short positions. They have taken the other side of the trade, and this type of set-up is normally resolved by a short covering rally.

Over the years, I have found it is wise to follow the lead of Commercial Hedgers. They are more highly capitalized than traders and have a vested interest to move the market based on their capitalization. No one knows how much longer Commercial Hedgers will build their long positions prior to the market moving higher, but certainly it is in their vested interest for prices to move higher at some point in time.

What could trigger a rally in the near-term?

The market declined this winter due to milder than expected weather in December and January, which allowed the storage deficit created by last winter’s record cold to be replenished. The EIA’s Feb 19^th weekly storage report indicated storage levels had returned to the 5 year moving average. But as you know the Midwest and Northeast experienced extremely cold weather in February and storage levels are again declining at an alarming rate. I believe inventory levels will end the winter heating season with approximately 1,400 Bcf in inventory, which would be 15% below the 5 year moving average.

Based on this estimate of inventory at the end of the winter heating season, I believe Natural Gas is extremely undervalued at the present time. What would be fair value? One simple measurement would be to compare the present price of $2.75 MMBtu to the 5 year average price of Natural Gas.

The chart below is a 10 year monthly chart of Natural Gas:

The red line in the above chart shows the 5 year average price of Natural Gas, which at the present time is $3.76 MMBtu. Therefore, with inventory levels projected to end the winter heating season approximately 15% below the 5 year moving average, I believe Natural Gas is extremely undervalued and as the market awakens to this reality traders will start covering their short positions and rates will likely return to and very possibly beyond the fair value of $3.76 MMBtu. Normally, this process takes approximately 3 months to be completed and for the market to come back into balance near fair value.

If you have not already hedged your cost of Natural Gas or Electricity, I recommend you do so ASAP. In my Feb 5th report, I wrote all the ingredients were in place for a major bottom. I said we could go a little lower near-term, but we could also be reaching the low for the year today. Therefore, if you have not secured your next hedge, I urge you to do so as soon as possible at these very low rates from an historical perspective.

As you can see in the chart below Natural Gas did in fact reach its low for the year the day after my last report and has been rallying ever since.

I believe the Feb 6^th low may prove to be the winter low prior to a spring rallying taking Natural Gas and Electricity to fair value, which is significantly higher than where it is today. Therefore, if you have not secured your next hedge, I urge you to do so as soon as possible at today’s very low rates from an historical perspective.

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