Tuesday, April 21, 2009

One Trader Likes Natural Gas Price Futures

There is no shortage of natural gas bears in the investment community. Natural gas prices have been falling for months and so far bearish bets have paid off.

But if they’re smart, the bears will take their profits now and hibernate for the rest of the year. Natural gas has bottomed and is ready to rally – big time.

Of course, the bears will argue otherwise. But they’re wrong… They’re letting logic cloud their thinking and it’s blinding them to the opportunity in front of them.

Logic says there is a glut of natural gas the market. Logic dictates the oversupply of natural gas should pressure prices lower until the forces of supply and demand deal with the glut. And logic is correct.

What the bears are missing here, though, is the market already knows this. The market knows there’s a glut. The market knows natural gas prices have to move lower to correct the supply-and-demand imbalance. And the market has already responded.

Last week, natural gas prices dropped as low as $3.50 per million British thermal units (BTUs). That’s as low as prices have been in nearly seven years. In fact, $3.50 is widely regarded as the "shut in" price for natural gas. That’s the price at which natural gas drillers are better off closing down the well than continuing because it costs more to extract the gas than what the drillers can sell it for.

In other words, natural gas cannot fall much below $3.50 before drillers start shutting wells. Once that happens, the forces of supply and demand start going the other way. And the market knows this…

Which is why natural gas bounced off of the $3.50 price level and is now trading at $3.86. The market has already discounted the natural gas supply glut. It started discounting it in the fourth quarter last year when, for the first time in a decade, natural gas prices fell during the last three months of the year.

Now the market is ready to start discounting a drawdown in natural gas supplies. The drawdown won’t happen immediately. Heck, it may not happen for several more months. But the market is a discounting mechanism. Prices will start to increase well before the fundamental factors support such a move.

We should soon see natural gas prices begin to trade more in line with their historic relationship with oil.

As you can tell from the following chart, it now takes roughly 15 million BTUs of natural gas to buy one barrel of oil…
Historically, this ratio has trended around 10. In fact, for most of the past decade, the ratio has been closer to eight.

The current 15-to-1 ratio is the most extreme reading of the past 20 years. This means one of two things has to be true: Either oil is too expensive or natural gas is too cheap.

If oil is too expensive, then oil prices will fall while natural gas holds steady. If natural gas is too cheap, then there’s the potential for a huge rally in the works.

Either way, the downside to buying natural gas right here is limited and the upside is huge.

Best regards and good trading,

Jeff Clark

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