Natural gas is one of the most undervalued commodities in my opinion. Since the start of 2009, natural gas has pulled back about 40 percent. The main issues surrounding natural gas are oversupply and less demand. However, a decrease in the rig count (supply) and industrial production increases (demand) could set the foundation for a strong rally.
The natural gas market at this point provides an opportunity very similar to the opportunity crude oil presented when it traded as low as $34 at the beginning of this year. Since the start of 2009, crude oil has made a strong rally from its lows, and I think natural gas can stage a similar rally.
The Supply Factor – Rig Count
Natural gas is supplied through U.S. rigs or wells that are dug into the ground. The rig count determines the supply of natural gas. The chart below displays the U.S. rig count for both oil and natural gas over the last five years. You can easily see that the rig count for natural gas has seen a dramatic drop in the last eight months.
The rig count is down about 50 percent from its high. Producers have sharply cut back on their supply and this will have a lagging effect in the coming months. If demand picks up, it will take some time before rigs come back online to meet the higher demand. Higher demand and low supply will always lead to higher prices. In natural gas, I think the market will start seeing higher prices in the next several months.
In 2001, something similar happened. The rig count for natural gas dropped from about 1,100 to 600 – a decline similar to what the market has seen in the last eight months. You can see in the chart below that the cut in supply coincided with the drop in price. However, it was followed by a strong rally during which the strained supply couldn’t keep up with the rebound in demand.
Could this happen again? I think it is very possible that we could see a similar rally because we are in a very similar situation to 2001.
The Demand Factor – Industrial Production
About 50-60 percent of natural gas consumption is from industrial demand. One of the best ways to gage industrial demand is to watch the monthly industrial production report. This report is usually released around the middle of the month by the Federal Reserve and is an important measure of the current output for the economy. Industrial production gives us an idea of how much factories, mines and utilities are producing.
Keeping track of industrial production is like keeping your finger on the pulse of the economy. The report shows which areas of the economy are growing and which are shrinking. An important part of this report is the capacity utilization rate, which is an estimate of how much factory capacity is in use.
You can track industrial production very easily on the Bloomberg Web site at the following link: http://www.bloomberg.com/markets/ecalendar/index.html
The chart below tracks industrial production on a monthly and yearly basis. If you focus on the monthly percentage change in the chart below, you can see the sharpest decline between July and October of 2008.
Toward the end of the year, we may see a surprise, and industrial production could come back. If industrial production comes back, demand for natural gas should rise. Combine this with the substantial supply cut that the market has already seen, and you have the building blocks for a potential bull market in the natural gas market.
Some might argue that it’s too early to expect improved industrial production and higher natural gas prices, but I’d rather be early than late. It happens far too often that investors and traders miss the strongest move in a bull market, only to get in when the market has peaked. Think of all those that were crushed after crude oil tumbled from its high near $150 a barrel last year. At that time, there were plenty of people predicting crude oil would top $200, but the major move had already been made.
There are a number of ways to position yourself to take advantage of higher natural gas prices. In addition to an outright futures position, there are also spreading strategies that can be utilized, such as shorting crude oil and going long natural gas. However, because there is a contract value difference between natural gas and crude oil, you may want to approach this kind of spread more strategically.
Since the markets are constantly changing, feel free to give me a call to discuss the mechanics of this spread. I’m also very happy to help you determine specific price entry and exit points on trades. Most importantly, you want to make sure you strategically position yourself in a market that is out of favor, and get in before it gets hot.
Phil Streible is a Senior Market Strategist with Lind Plus. He can be reached at (800) 803-8037 or via email at pstreible@lind-waldock.com.
You can hear market commentary from Lind-Waldock market strategists through our weekly Lind Plus Markets on the Move webinars . These interactive, live webinars are free to attend. To sign up, visit https://www.lind-waldock.com/events/calendar.shtml. Lind-Waldock also offers other educational resources to help your learn more about futures trading, including free simulated trading. Visit www.lind-waldock.com.
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