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November 25, 2005

Trading Natural-Gas Stocks
by Adam Hamilton

You wouldn't know it from the gloriously sublime autumn with which we have been blessed in much of the US, but winter is inexorably approaching. As inevitable as winter is the mainstream interest it generates in natural gas as cold temperatures drive higher heating bills.

Natural gas is really fascinating stuff on many levels. It is primarily methane, the lightest hydrocarbon molecule. It is burned to drive turbines in electrical-power-generation plants, to heat homes and businesses across the nation, and as a feedstock to produce the agricultural fertilizer ammonia. It is one of the most important economic commodities in the US today after crude oil.

But unlike the global crude-oil markets serviced by great supertanker fleets, natural-gas markets remain largely regional or continental at best. Vast gas deposits exist in remote regions of the world, but gas deposits in the US are rapidly being depleted. Gas can be efficiently moved from areas of high supply to high demand via land pipelines, but undersea pipelines are uneconomical and impractical for ocean transport.

Today more gas is being liquefied, supercooled to -260°F which shrinks its volume by 600x, and transported across the seas in tankers, but so far this LNG industry remains small relative to total gas consumption. While LNG tanker fleets may rival crude-oil supertankers someday, so far they have not overcome the inherent locality of the natural-gas markets. As gas consumption in the States grows, prices have to climb since gas cannot yet be imported on the same scale as oil.

Thus, for many years to come in the States, natural-gas demand growth will exceed supply growth keeping US gas prices high. As investors and speculators, this structural deficit creates a marvelous fundamental opportunity for us to profit. The elite gas companies that are drilling, pumping, and transporting the scarce gas to market are in an amazing position to reap legendary gains for years.

The best place to start investigating natural-gas stocks is in their premier sector index, the XNG. The XNG is the Amex Natural Gas Index. It currently contains 15 component "companies in the natural gas industry involved primarily in natural gas exploration and production and natural gas pipeline transportation and transmission." The XNG was born in October 1993 and is equally weighted with a quarterly rebalancing.

A couple weeks ago I discussed the weighting problems inherent in the XOI Amex Oil Index. Its share-price weighting gives tiny companies an enormous impact disproportionate to their true market importance. Even though the natural gas and oil indexes both have the same custodian, thankfully the equal weighing in the XNG greatly reduces similar problems in it.

Actual XNG weightings run from 6.1% to 7.5% while the true component market-cap weightings range from 0.9% to 14.6%. While I still think market-cap-weighted indexes are superior, the XNG's equal weighting makes far more sense than the XOI's share-price weighting. And the XNG companies are much smaller than oil companies anyway, which further reduces index-weighting distortion. The XNG is capitalized at $192b while the XOI is running closer to $1000b.

With a sector index to track as a proxy for natural-gas stocks in general, we can examine how gas stocks have tended to trade so far in their bull to date. By examining their technical behavior including typical uplegs and corrections as well as their correlation with potential drivers including the natural-gas prices, we can greatly improve our odds of discerning major interim lows and highs in the future. Then we can attempt to buy low and sell high and ride this gas-stock bull.

Our first chart this week combines a study of average XNG uplegs and corrections with the index's Relativity analysis. Like all bull markets the XNG tends to advance away from its 200-day moving average in uplegs and converge back to it in periodic corrections. The Relative XNG, or rXNG, divides the index by its 200dma to express this relationship as a constant multiple. The resulting red line creates a horizontal XNG trading band discussed further below.

Before we delve into the rXNG, it is really useful to examine the XNG itself technically. Understanding how it has performed so far builds a solid probability foundation under our expectations for future performance. Bull to date since its birth in 2002 the XNG has had eight separate upleg/correction cycles. The bull-to-date high at the top of each cycle is numbered above and upleg gains and correction losses for each cycle are noted.

The first five cycles formed an initial uptrend channel that lasted until mid-2004. Since then the XNG's uptrend has steepened a bit as defined by the latest three cycles. Accelerating upslopes in bull markets are normal and expected and we have already witnessed them in gold stocks, silver stocks, and oil stocks. Today the index's primary support is running near 350, just under its 200dma. The XNG may very well pull back to these levels before marching higher, although it certainly isn't necessary.

All eight upleg and correction cycles witnessed average upleg gains of 33% from the beginning of the cycle to its bull-to-date-high apex. If the XNG does indeed retreat to its support near 350 before surging again, a 33% gain from those levels would yield a new upleg target of 465. While future uplegs won't be exactly like past specimens, speculators need to know that past probabilities favor gains hovering around 33%. So when future uplegs exceed this benchmark traders need to be cautious and prepared for a correction.

These corrections from each cycle top to its subsequent major interim low have averaged 12% bull to date. This is really pretty mild within the context of a secular bull, reflecting the relatively tranquil nature of the natural-gas stocks compared to volatile speculations like gold stocks. The smooth gradient of this gas-stock bull so far makes it perfect for investors since even 20% trailing stops wouldn't be universally triggered in a typical correction. This is far more sedate than gold stocks, which have averaged 98% uplegs and 27% corrections.

Interestingly our current correction since early October is already off 16%, the second largest correction in this bull so far. In light of the preceding upleg eight though, this definitely makes sense. Following the hurricanes hammering the Gulf Coast natural-gas prices spiked mightily and gas stocks followed them up. Once the dust settled and it became apparent that the storms didn't quite knock natural-gas infrastructure back into the Stone Age, the XNG corrected sharply from its spike highs.

The periodic corrections witnessed in the XNG bull form an extremely well-defined lower relative support line. Shaded in light green above, note how the XNG has tended to bounce right around 1.06x its 200dma. In seven of its eight upleg/correction cycles the correction ended pretty darned close to 1.06x relative. Even this latest sharp correction has exhibited a tendency to respect this 1.06x support and bounce higher twice now.

While it is entirely possible that our current correction will go lower since reaction corrections off event-driven spike highs tend to be steeper and deeper, gas-stock investors and speculators would do well in the future to watch the 1.06x relative level. Whenever the XNG slides after a new bull-to-date high and grinds down to within 6% of its 200dma, odds are that will signal a great time to add long gas-stock plays.

Unfortunately the rXNG resistance band, rendered in red above at 1.24x the XNG's 200dma, is not as crystal clear as its support. The XNG's major uplegs have topped in a wide range running from 1.15ish to over 1.30ish so the rXNG sell zone is not as clear as the buy. But the last several XNG uplegs, which are the most interesting and relevant to traders today due to their recent occurrence, have tended to top around 1.24x.

Thus, when future XNG uplegs start pulling 24% or so above their anchoring 200dmas, it is prudent for speculators to start preparing for a pullback. This can range from ratcheting up trailing stops on stock positions to selling gas-stock calls to buying gas-stock puts. Thankfully catching tops is not as important as catching bottoms for stock speculators since trailing stops can be used to let the markets automatically close positions when the time is right with no emotional angst.

This analysis helps us better understand the probabilities that have governed the XNG bull so far. It has tended to run 33% higher in major uplegs and correct 12% in major corrections. And the index has been fairly consistent in running in a range of 1.06x to 1.24x its 200dma. In the future when the XNG exceeds these established averages speculators can assume the probability of an imminent reversal is higher than normal and act accordingly.

While understanding the technical nature of a particular bull provides invaluable real-time insights moving forward, traders need to dig even deeper. In order to increase the odds of successfully anticipating a great trading opportunity like a major interim top or bottom, it is important to find the drivers of a particular bull market. Gold prices are definitely the primary driver of the gold-stock bull, but are natural-gas prices driving tactical trends in the XNG?

Prior to doing this research work I assumed the answer to this important question would be yes, and indeed it probably is on a long-term strategic basis. But over the short-term frames of reference, such as the individual major upleg/correction cycles, the apparent XNG drivers were surprising. Amazingly, on an individual-cycle level natural gas did not appear to be the most influential driver of the companies that produce and distribute it!

One way to analyze potential drivers is with tactical correlation analysis. The statistical correlation between the XNG and other prices can be analyzed to see where the greatest parallels lie. The following three charts analyze the XNG's correlation with other prices over the same eight upleg/correction cycles discussed above. Under each correlation number is its corresponding r-square percentage, which reveals how likely daily movements in the XNG can be statistically explained and predicted by movements in other prices.

On this chart the blue series with the black, white, and yellow technicals is natural gas and the XNG is rendered in the background in red. As the technical trend lines clearly reveal, natural gas is in a secular bull market. It has climbed from $2 in early 2002 to $15 just recently, and the center of its trend channel is now near $8. This 782% gain for this commodity is staggering. By comparison gold is only up 92% in dollar terms in its own bull.

Even if natural gas was to correct back down to its lower support under $7, its bull market would still be spectacular compared to most other commodities. Note that at today's $12ish levels natural gas is twice as expensive as last winter's $6ish levels. This is why the mainstream media is making a big deal out of scaring Americans with prognostications of 100% gas-bill increases this winter. Really though, gas should continue correcting as parabolic spikes are never sustainable as its early 2003 example illustrated.

So natural gas is inarguably in an awesome bull market. And natural-gas stocks' profits should soar with gas prices driving them up in concert. And indeed the XNG has risen nicely, up 300% bull to date since mid-2002. There is no doubt that over the long term gas prices will drive gas stocks, as higher profits lead to higher stock prices. But over the short-term, surprisingly, gas is not that strong of predictor of XNG levels.

Overall in the chart above the XNG and natural gas had a 0.803 correlation. This may sound high, but it is really the correlation squared, or r-square, that is useful to speculators, not the raw correlation. A 0.803 correlation only yields an r-square of 64%. Only 64% of the daily behavior of the XNG over the past four years or so could be explained or predicted by natural gas on a strategic level.

If we average the r-squares for each of the six positively-correlated individual upleg/correction cycles in the XNG, the results are even less encouraging. Only 49% of the daily movement in the XNG could be explained by natural gas's machinations. This leads me to suspect that monitoring natural gas itself is not likely to be particularly useful for gas-stock traders. Gas stocks will follow gas strategically, but tactically they seem to do whatever they want.

This surprise creates something of a quandary. Just as watching gold's technicals is useful for trading gold stocks and watching oil's technicals is useful for trading oil stocks, I had assumed natural-gas technicals would offer buy/sell timing clues for gas stocks. These external signals not bound within the index technicals themselves have proven invaluable in this great commodities bull so far. Risks multiply when a sector is traded solely on its own intrinsic technicals with no external fundamental driver to verify buy/sell signals.

Surely the XNG is correlated with some external factor that could help us time it. Since oil stocks have had fairly high correlations with the general stock markets in recent years, I decided to see if the XNG was correlated with the S&P 500. It is certainly possible that gas stocks are largely held by mainstream investors and therefore buffeted about by the same forces that drive major uplegs and corrections in general stocks.

Indeed there have been periods of time when the XNG was tactically correlated with the SPX, especially in the early days of the massive bear rally in stocks in 2003. The overall strategic r-square of this pairing is 68%, slightly higher than that of the XNG and natural gas. But if you carefully analyze this chart, over the past two years the earlier high XNG/SPX correlations have all faded.

Overall, when the r-squares of the seven positively-correlated XNG upleg/correction cycles are averaged the result is 48%. This is pretty ironic as it is just 1% below the similar 49% tactical average of the XNG and natural gas. And in the last three XNG cycles, the average r-square of its SPX correlation has plummeted to 30%, which isn't even worth pondering. Thus, general-stock action probably won't tell us much about future XNG uplegs and corrections.

Now at this stage in my research I was disappointed. The XNG didn't correlate with natural gas well enough to trade in a tactical sense nor did it correlate with general stocks. We could certainly trade elite gas stocks solely using XNG technicals, but I prefer not to do this as no external signal confirmations multiply the risks of misinterpreting XNG signals. I slept on it for a day and was watching Bloomberg early the next morning while working out and heard some commentator talk of "oil and gas stocks" as if they were a single sector.

As I was lifting weights I was wondering if it could really be that simple, if the XNG mimicked the oil stocks to a high enough degree that we could use the oil stocks to confirm XNG signals. So I built another spreadsheet and made this final chart comparing the XNG to the XOI oil-stock index. The results were stunning. Apparently the XOI is like the holy grail of external timing for natural-gas stock signals!

The correlations between the XNG and XOI are so high that they may as well be one sector, I have never seen anything like this in all my previous market studies. Strategically these entire four years have a stellar r-square of 95%. Fully 95% of the daily XNG price action in this entire bull has been explainable and predictable by the daily price action in the XOI oil stocks. And this relationship held tactically too.

When the r-squares of the seven XNG cycles with positive correlations are averaged, the result is 93%! And the average of the last four XNG cycles, the most relevant to today's traders, is 96%. This level of correlation is just off the charts. Oil stocks and gas stocks don't seem to trade as two independent sectors driven by their own very different fundamentals, but as one common energy-stock sector. XNG traders therefore need to monitor XOI and oil technicals very closely to help time XNG trading decisions.

Why is this? There are a couple theories I have been pondering.

Compared to oil stocks, gas stocks are a small market. This is similar to the relationship between gold stocks and silver stocks, the silver stocks' capitalization is dwarfed by gold stocks. What if most gas-stock investors and speculators are primarily oil-stock investors and speculators? If so, they probably concentrate on trading oil stocks and buy/sell gas stocks on the periphery at the same times they are already buying/selling oil stocks.

Gas stocks may be somewhat of a little-sister market to oil stocks like silver stocks are to gold stocks. Silver-stock investors are sometimes confounded when silver stocks are far more highly correlated with gold-stock levels than with silver, which would make much more fundamental sense. This is because most silver-stock traders are primarily gold-stock traders and they look to gold for their timing cues. The relationship between gas stocks and oil stocks may be similar.

Another possibility surrounds the nature of the oil and gas extraction industries. A great deal of the natural gas produced is either produced by primary oil companies and/or is a byproduct of oil production. As such, the majority of natural-gas profits may accrue to primary oil companies anyway. This could cause investors to mentally group the remaining independents specializing in gas into an oil-driven trading paradigm.

Regardless of the reasons, gas stocks have traded like oil stocks in this bull to date. We have already integrated this knowledge into our trades. In our premium Zeal Speculator alert service, in the last couple weeks we have bought and recommended gas stocks and gas-stock call options since gas-stock prices are looking relatively low these days. This campaign is just getting started and we hope to layer in more trades soon. Please subscribe today if you are interested in this excellent gas-stock opportunity!

The bottom line is gas stocks are in a secular bull market that is likely to last for years. Natural-gas demand growth is outstripping supply growth in the US and companies involved in this industry are going to thrive on persistently higher gas prices. Higher gas prices mean higher profits which ultimately lead to higher stock prices as investors bid up gas stocks to chase these profits.

Gas-stock investors will probably win big in the coming years, and watching XNG technicals and oil-stock levels will probably yield great trading signals for buying and selling gas stocks.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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