Natural Gas - The Other Bull?

By: Henry To | Mon, Aug 1, 2005
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Dear Subscribers and Readers,

We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. Since July 14th, the major market indices has more or less stayed flat - but in the last couple of weeks, we have witnessed many negative divergences - such as the breakdown of the large caps like Yahoo, Intel, Microsoft, and now potentially Google - and even eBay which, despite the recent rally, is still sitting below its 200 DMA. Of course, we all know that the small caps and the mid caps have continued to rise, but history has shown that such a rise is not sustainable until the large cap indices (and a blue chip index like the Dow Industrials) confirm that rise as well. As you know, we had anticipated switching from a 25% short position to a 50% short position in our DJIA Timing System sometime last week - but new developments (please see our MarketThoughts Ad Hoc Update that we emailed you on Friday morning) over the last week had convinced me that this rally could still make one more move to the upside. Since tops are inherently difficult to call, I am giving this market the benefit of the doubt - although we will still be looking to switch to a 50% short position within the next several weeks.

I hope you all enjoyed Bill's guest commentary on Thursday morning in a discussion of the equity put-to-call ratio and its usefulness in predicting future short-term market trends. Even though it may be too quantitative for some our readers, I believe nonetheless it was a good introduction on how to construct basic market models or timing systems A few of our readers have expressed a great interest in that article, and this has inspired us to create a separate board in our discussion forum - Trading Systems and Market Timing Models - which will allow our subscribers and readers to discuss and share their views on how to construct models and timing systems, as well as to post their predictions and results. I look forward to increasing participation in that board going forward.

Let's now get on with our commentary. Readers and subscribers alike must be getting sick and tired of all the talk out there about crude oil - and so you probably won't need to hear any anymore from us on that subject. Let's also face the fact that we haven't been exactly correct in our prediction of oil prices (although this author still thinks that oil prices will eventually decline below $50 a barrel within the next six to nine months). While the supply/demand figures "released" by OPEC are very opaque - the crude oil market is still dominated by professionals in the industry and hedge funds alike, and chances are that retail investors will have a very difficult time trying to make money by timing the "wiggles" in the price of crude oil. Better to hold a well-diversified basket of oil companies if one is structurally bullish in the price of crude oil going forward.

Since the subject of crude oil investing/speculation has been discussed so widely already, this author would like to discuss a commodity that has been practically out of the news since the winter of 2000/2001 and the fall and subsequent bankruptcy of Enron. Such a commodity is natural gas. Throughout the development of modern society, the preferred energy source has gradually transitioned from a commodity which contains a high carbon-to-hydrogen atom ratio (such as wood and charcoal) to a commodity that has a lower such ratio (such as oil and now natural gas). The current goal of modern society is to eventually transition to using hydrogen only as an energy source. Whether we can accomplish this relatively quickly will depend on how determined we are to end our addiction to Middle Eastern and Russian crude oil.

But that's a story for another day. The point is that natural gas demand throughout the world will increase at a greater rate than crude oil demand going forward. It is also a more attractive fuel - as it releases fewer pollutants in the air. Moreover, natural gas supply and demand data is much more accurate and easily available - as 80% of our natural gas consumption is still supplied by domestic producers. Of the remaining 20% of demand, 80% of that demand is filled by Canadian producers - with the remaining 20% (4% of the total) coming from LNG imports.

So Henry, what is the story here? Why do you think the story is compelling - given that 80% of U.S. consumption is still supplied by domestic producers? Doesn't this indicate that there are still ample natural gas supplies in the world? Well, this subject has been discussed on and off previously but I will now attempt to summarize why we are bullish on natural gas prices.

Lower-48 Dry Gas Production vs. Dry Gas Productive CapacityFirst of all, even though natural gas consumption in the United States effectively peaked in 2000, it is expected to steadily increase going forward - despite the fact that there has been significant demand destruction in the industrial sectors during the natural gas spike of 2000/2001. More importantly, the fact is that natural gas is now where oil was back in the early 1970s - in that starting in the late 1990s, natural gas became a major part of the U.S. energy infrastructure concurrent with the release of ample evidence that both U.S. and Canadian supply has most probably peaked. For example, while rig counts in the United States has increased over 80% since 1997, the domestic production of natural gas actually slightly declined. The following chart by Mr. Kevin Petak, an economist with Energy and Environmental Analysis, Inc., illustrates this perilous supply situation perfectly:

As shown on the above chart, productive capacity of the lower 48 states of the United States has steadily declined since the mid 1990s - with only a brief interlude after a rush of drilling projects following the 2000/2001 winter upside spike in prices. Moreover, since 2001, gas production levels have been pretty much kept pace with productive capacity - suggesting that there is NO SPARE PRODUCTION CAPACITY left in the lower 48 states of the United States.

This declining trend is also evident in Canadian production of natural gas. In a December 2004 report outlining the short-term deliverability of natural gas in Canada, the National Energy Board stated that the "effective decline rate for production from existing wells is expected to remain at around 21% per year. This means that new connections would need to replace over a fifth of the previous year's output to keep overall production constant." Moreover, the "trend of lower initial productivity in new WCSB gas wells [the Western Canada Sedimentary Basin - which currently accounts for 98% of total Canadian production] is continuing. Consequently, to offset production declines from producing wells, the number of new gas connections must rise each year to maintain production levels. The Board expects that the number of gas wells drilled would need to increase from 15,100 in 2003 to about 15,600 in 2004, and 17,900 by 2006 in order to maintain current production." In other words, Canadian production has most probably peaked as well. Coupled with the fact that Canadian demand for natural gas is also projected to increase steadily each year, my guess is that Canadian natural gas export levels to the United States should steadily decline going forward.

A further bullish development for natural gas is the fact that natural gas has had a very good historical correlation with crude oil prices. Following is a chart showing such the correlation between the month-end spot prices for natural gas vs. WTI crude from November 2003 to July 2005:

Month-End Henry Hub Natural Gas vs. WTI Crude Oil Spot Prices(November 1993 to July 2005) - 1) Historically, natural gas prices have pretty much tracked crude oil prices here in the United States.  More importantly, the historical volatility in natural gas prices is far greater than that of crude oil (as noted by the wider movements in natural gas prices and by the two upside spikes at the end of December 2000 and February 2003).  Given the wide variations in weather patterns in recent years and give the tight supply situation, I think we are overdue for another such spike. 2) Natural gas prices lagging?

Granted, the forward price for January 2006 is over $9.30/MMBtu as I am typing this, but this does not diminish the fact that the current spot price for natural gas is severely lagging that of crude oil prices. Moreover, natural gas prices have historically had periods where they have "over-performed" oil prices, and this is usually evident during the winter months (December to February). In a high demand (unusually cold weather) environment and assuming that oil prices stay at $60 a barrel during the winter, I would not be surprised to see a "sustainable" natural gas price of $15 to $17/MMBtu somewhere during that timeframe (assuming this historical relationship holds). We are also overdue for such an upside spike.

Of course, a more immediate concern for the speculators is whether this structurally bullish environment for natural prices could translate to a more short-term or intermediate term gain - since bull markets don't move up in a straight line. Here at MarketThoughts, we are usually very concerned about this too - since as a rule, we don't usually like to buy stocks that are already in an overbought situation or conversely, sell or short-sell stocks in an oversold situation. For readers who are seriously thinking about taking advantage of rising natural gas prices ahead, it is comfortable to know that the bullish sentiment (as measured by Market Vane's) is really not that prevalent among investors when it comes to natural gas - as evident by the following chart:

Henry Hub Natural Gas Spot Prices vs. Bullish Sentiment(January 2001 to Present) - Bullish Sentiment still very low relative to sentiment in prior peaks - suggesting that investors are skeptical of the recent rally in natural gas prices...

For readers who are seriously interested in buying shares of companies that can take advantage of rising natural gas prices ahead, you may want to start off by taking a look at the components of the American Exchange Natural Gas Index. As far as I know, this author does not know of any HOLDRS or ETFs that will directly take advantage of rising natural gas prices. Please keep in mind, however, that certain components of the American Exchange Natural Gas Index may already be very overbought.

Let's now discuss the most recent stock market action. As our readers know, this author is still very suspicious of the recent rally - all the more so given the fact that the bulls are now heralding the death of the Dow Industrials as a reliable indicator of market conditions and as both the mid cap and small cap stocks continue to make highs after highs. A frequent poster on our discussion forum, Mr. Gizmo, has posted a link to a very good article written by Dr. John Hussman of the Hussman Funds discussing this particular phenomenon. Such an observation attests to the usefulness of the Dow Theory, as well as the two "brand name watching" commentaries that we have written over the last few months or so. As I mentioned last week: "Historically, the underperformance of both the Dow Industrials and the Dow Transports has been a great warning to investors - as was the case in the October 1966 to December 1968 cyclical bull market (when most investors were ignoring the Dow Industrials and the Dow Rails - choosing to invest in small caps instead as the Barron's Low Priced Stock Index kept on making all-time highs week after week), the all-time high in May 2001 (not confirmed by either the Dow Industrials and the Dow Transports and immediately before a huge four-month decline in all the major indices), as well as the all-time high made in April to May 2002 (again, not confirmed by either the Dow Industrials and the Dow Transports and immediately before a 30% decline in the S&P 600 as shown below)." I am still sticking to this view.

The divergence is again evident in the action of the Dow Industrials in the latest week, as signified by the following daily chart of the Dow Industrials vs. the Dow Transports:

Henry Hub Natural Gas Spot Prices vs. Bullish Sentiment(January 2001 to Present) - Bullish Sentiment still very low relative to sentiment in prior peaks - suggesting that investors are skeptical of the recent rally in natural gas prices...

Over the last two weeks, the Dow Industrials basically stayed flat, while the S&P 400 and S&P 600 rose 2.0% and 2.4%, respectively. The Dow Transports, of course, significantly outperformed - rising a total of 4.2% over the last two weeks. The question to ask now is: Will the strength of the Transports eventually overwhelm the weakness of the Dow Industrials or is the weakness of the Dow Industrials a warning sign? The cautious Dow Theorist will say "I don't know" but I am opting for the latter. For now, I am still relatively comfortable staying 25% short in our DJIA Timing System - all the more so given that the Dow Industrials has been the weaker index since the beginning of 2004.

This commentary will be in a slightly different format, as I want to start off our discussion of our most popular sentiment indicators by first discussing the Market Vane's Bullish Consensus readings over the last couple of months, and how overbought they are now on a historical basis. Following is the latest weekly chart showing the Market Vane's Bullish Consensus vs. the Dow Industrials:

DJIA vs. Market Vane's Bullish Consensus(January 2002 to Present) - The Market Vane's Bullish Consensus declined slightly from 69% to 68 this week - resulting in one of the longest strings of >65% readings in this survey that we have seen in awhile.  The ten-week moving average of this reading continued to rise - rising to 68.1% - a new seven-year high reading and matching the previous high set during mid April 1998. Is this survey signaling an imminent top?  Or should we wait for 'confirmation' from the other two sentiment surveys/indicators?  My inclination is to wait, but once the other two sentiment indicators have confirmed - watch out below.

As we mentioned in the above chart, the ten-week moving average of the Market Vane's Bullish Consensus is now at its most overbought reading (68.1%) since mid April 1998. If the upcoming weekly reading is 68% or above, we will see a new eight-year high on this reading - a reading not seen since late August 1997 - right before the unfolding of the Asian Crisis severely punished the U.S. equity markets as well. No matter which way you look at it, this survey is now flashing a major "danger" signal.

Of course, as we mentioned last week: "Nothing is obvious." And while the most optimal scenario would be for the AAII and Investors Intelligence Survey to confirm the overbought readings in the Market Vane's Bullish Consensus as well, we are still not seeing such a confirmation - although we may be getting quite close. Let's now turn to the Bulls-Bears% differential readings in the American Association of Individual Investors (AAII) Survey:

DJIA vs. Bulls-Bears% Differential in the AAII Survey(January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey is getting increasingly schizophrenic - rising quickly from a somewhat oversold reading of 13% back to an overbought reading of 40% in the latest week.  If the Bulls-Bears% Differential stays at the 40% level or higher this coming week, then this would have confirmed the overbought sentiment readings coming out of the Market Vane's Bullish Consensus.  That is, whether we turn 50% short in our DJIA Timing System later this week will depend on a great deal on what this and the Investors Intelligence Survey is telling us.

The latest one-week reading of the Bulls-Bears% Differential in the AAII Survey rose back up relatively quickly - jumping from 13% to 40% in the latest week - once again rendering this survey in an overbought condition. However, such a one-week reading cannot be viewed as a confirmation of the overbought readings in the Market Vane's Bullish Consensus. This author would like to see the upcoming week's reading reach an even higher level before labeling it a confirmation. More importantly, we will not shift from a 25% short position to a 50% short position in our DJIA Timing System before we have obtained such a confirmation.

Of course, we also shouldn't overlook the sentiment readings from the Investors Intelligence Survey either:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey(January 2003 to Present) - Okay, the Bulls-Bears% Differential in the Investors Intelligence Survey got slightly more overbought last week - rising from a reading of 29.6% to 33.3%.  However, my message from last week still remains the same - said message being that before we can confidently call a ST top in this market, the reading in this survey will need to surge to a level similar to the December 2004 levels of 40% (or even higher).  Based on the current readings from this survey, my guess is that we are at least a couple of weeks away from such a ST top.

Out of the three popular sentiment indicators that we keep track of, the Bulls-Bears% Differential in the Investors Intelligence Survey is the least overbought - with the latest one-week reading rising from 29.6% to a slightly overbought reading of 33.3%. In a "perfect world," we will also wait for the Investors Intelligence Survey to rise to a reading of 40% or above we shift to a 50% short position in our DJIA Timing System. For now, we will just take it one day at a time and we will definitely keep you updated - but if the right conditions exist, I would not hesitate to shift to a 50% short position before we see a reading of 40% or above in this survey - as long as the readings coming out of this survey doesn't tank below 30%.

Conclusion: For investors who are adventurous and who are getting wary of holding energy stocks with a significant crude oil exposure, natural gas shares or the commodity also offers a compelling buy - although a significant number of energy stocks that one is holding are probably already diversified into natural gas. For investors who want some pure exposure into natural gas, you may want to begin by checking out the components in the American Exchange Natural Gas Index. As always, be sure to do your utmost due diligence before jumping in - since some of those companies are mostly distribution companies (that is, they just own the pipelines which deliver the natural gas) or who have hedged some of their supplies. I am structurally bullish on natural gas going forward, and unless we start building a dozen LNG terminals tomorrow, it is not too difficult to envision a scenario where we see continued upside spikes (during the winter) in natural gas prices in the next few years - possibly to at least $15 or even $20/MMBtu.

As for the equity markets, I am still giving the benefit of the doubt for the bulls here. We will continue to remain 25% short in our DJIA Timing System, although we are definitely looking to switch to a 50% short position within the next couple of weeks. This author would like to see more negative divergences and more overbought readings in our sentiment indicators before we switch to our maximum allowable short position - since as we have mentioned many times before - tops are just inherently difficult to call. For readers who are ticker hounds, I would also recommend keeping track of the day-to-day movements in the Rydex Cash Flow ratio.

Signing off,


Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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