Finding Good Value in Energy -- Natural Gas

By Frank Barbera CMT. June 5, 2007

Over these last few months, it has undoubtedly been a frustrating period of time if you are a ‘value’ investor. Very few markets have been passed over by the long boom in cheap credit, which has spilled excess liquidity into massive pools of capital. In turn, those pools of capital have combed the world over, in an ongoing quest to seek hidden values driven by a seemingly unquenchable thirst for ever greater levels of asset inflation, and ever greater levels of total return.

Amid all of this hedge fund arbitrage, it is possible that some stone has been left unturned by the performance gods of global capitalism? In our view, while it is hard to believe, we do see pockets of “good value” remaining within the Energy Sector. Yes, we know that Oil Shares are still not expensive on a fundamental P/E metric, and in light of the coming age of Peak Oil, in all likelihood, we will all look back one day with fondness on the “low price” of Crude Oil near $73. “Remember the time when Crude Oil cost less per gallon than Milk?” That will probably be a common refrain. Yet, Oil Stocks have had an enormous advance in the last few months, and will undoubtedly not fair that well in a more generalized market decline, that is, IF a decline of substance ever materializes.

Despite cheap P/E’s, both Oil and Oil Service stocks could become a victim of their own recent success, as equity fund managers could be tempted to hit the “take profits” button on Energy, if other segments of their portfolio begin to act poorly. Surely, this would never happen with professional money managers you say? Don’t kid yourself. All too often equities with big gains can become the “redemption bank” of first choice for managers who are being forced to sell equities and raise cash. Thus, despite our longer term fondness for Energy Stocks, at the moment, it is hard to belly up to the bar with the XOI up a hefty 34% since the mid-March low, and the OSX up an even more impressive 39%.

So where does one find “Value” in Energy at the present time? Our answer: Natural Gas. For a time, we were tempted to title this article: “Got Gas?” But then we thought better of that idea. Hence the more conservative approach shown above. Nevertheless, having Gas could be just the ticket over the next few months if you are in the market for solid investment gains. Mind you, we are not talking about Gas Stocks, No, No, No! We are strictly interested in gas -- the commodity. So why Gas? Well, Gas is cheap. How cheap? Answer: Very cheap, and therein lies the opportunity.

We start our discussion of cheap gas prices by acknowledging that a barrel of Oil has about six times the energy content of a thousand cubic feet of Natural Gas. Although the two commodities are far from perfect substitutes, there are any number of companies that can switch between Oil and Natural Gas depending on price and availability. A goodly portion of the US Electrical Utility Industry has this capacity with Natural Gas, a clean burning fuel of choice.

The graph below shows the price of Oil (West Texas Nat Gas Wellhead $/1000 cu ft and West Texas Intermediate Crude $/barrel) and is a fair representation of the historical relationship between the two commodities.

Above: Crude Oil (thick dark line) and Natural Gas (adjusted in Oil Equivalent)

Yet there is much more we do to illustrate this important point. In the next chart, we plot the price of Natural Gas on the top clip, and then the Spread between Crude Oil and Natural Gas converted into its Oil Equivalent value. It is this lower chart of the Natural Gas Spread that really highlights the magnitude of the current situation. On the chart, we have plotted 1.5 Standard Deviation Bands around a long term 2 year moving average. At the present time, the Spread of Natural Gas versus Crude Oil shows us that Gas is actually outside its long-term lower band, just a bit more than two standard deviations away from the moving average. In the past, prior periods of equivalent under-valuation led the path forward for Natural Gas prices to move steadily higher for months on end.

Above: Natural Gas (top clip) and the Spread between Natural Gas and Crude Oil with long term standard deviation bands (lower clip)

Still not convinced that Gas is cheap? OK, we took the analysis another step further by plotting a linear regression line against the Spread from early 1995 to present. We then detrended the spread around the Linear regression line to arrive at an oscillator, which once again shows just how oversold and depressed gas prices are at the present time when viewed from a historical point of view.

Above: the Crude Oil to Natural Gas Spread with long term Linear Regression Line.

Above: Natural Gas (upper clip) and lower clip, the differential between the Nat Gas/Crude Oil Spread and the long term Linear regression line.

Still one more approach can be used shifting from the world of statistics to the world of Technical Analysis. In the next chart, we show Crude and Natural Gas plotted over the last 12 years with their 200 day moving averages. At present, Crude Oil is currently 17.47% percent ABOVE its 200 day moving average, while Natural Gas is 11.53% BELOW its 200 day moving average. If we now subtract the two spreads (+17.47% - (- 11.53%)) = 29.00% we arrive at a figure of +29.00%.

Above: Crude Oil and Natural Gas with 200 day Moving Averages.

and their 200 day Moving Averages

Historically, whenever the composite of these two moving average spreads has been in the +25 to +30 or higher range, Natural Gas has been a good buy. Now, has this been a perfect indicator? Can you trade it? First off, there is no perfect indicator, doesn’t exist for any market, anywhere. Never has, never will. Second, this is long range in nature, and most certainly is of absolutely no use to the average futures trader whose long term time horizon by definition has to be about 10 minutes. No, this type of analysis is only oriented for those who are interested in an investment, which by definition entails holding onto the position for a period of weeks and months, perhaps longer

Above: Nearby Continuous Natural Gas prices, and Below: The New Natural Gas ETF symbol: UNG

Fortunately for those us who are investment oriented, the good folks at Barclays who brought out the popular USO Crude Oil ETF, have recently issued another ETF, this time for Natural Gas. The ETF, like all ETF’s, can be bought and sold just like any other stock, allowing investors the opportunity to track the futures price of Natural Gas to a reasonable degree. While almost all futures related ETF’s do have some tracking error, the UNG Fund appears to track Natural Gas fairly well, albeit, there are only two months of history. Down nearly 25% in just the last two months, we suspect that UNG is getting very close to, or may have just seen an important price low.

What other factors can influence Natural Gas? Well, probably no market is more seasonally oriented than Natural Gas where stockpiles rise and fall each year influenced to an enormous degree by the severity of both hurricane season and winter weather. Going into the Prime Seasonal period for Natural Gas, we find that stockpiles are actually bottoming this year at historically high levels, owing to the fact that last year's milder to nearly non-existent winter did very little to draw down above ground supplies toward historic lows. That said, going back through the data, we noted that early August tends to be the prime point for Natural Gas prices to begin a strong rally with seasonal lows in July 2006, May 2004, August 2002, July 2000, July 1999, July 1997, July 1995, July 1993, and July 1992. Typically, if Gas prices aren’t acting well by early September it could be a sign that either inventories are too high, or the hurricane season was very mild.

Above: Natural Gas prices with EIA Annual Above Ground Stockpiles.

Finally, another reason we like Natural Gas at the present time is the classic contrary opinion idea of “buying straw hats in Winter.” On the next chart, we plot a long term Standard Deviation measure which shows that at the present time, price volatility is -- believe it or not -- near historical lows for Natural Gas. Normally, when volatility is very low, you are looking at a good point, at least a lower risk entry point from which to start an investment campaign. While all of the usual disclaimers apply, and we do not intend to recommend any specific securities, investors willing to do their own homework might well come to the same conclusion that unloved Natural Gas could be a market of some interest.

Above: Natural Gas prices and Standard Deviation. Volatility is now near historic lows. Got Gas?

Speaking of Energy, higher Gas prices along with higher Energy prices and some weak retail news put downside pressure on the stock market today, where the S&P 500 tumbled 21.73 index points or 1.42% to close at 1510.12, while the DJIA ended lower by 151.77 index points or 1.11% to close at 13,498.20. On the NASDAQ prices slid sharply, with the Composite ending at 2639.15, down 30.87 index points or 1.16%. Gold ended modestly higher, gaining $2.20 the ounce to close at $664.70 on the August contract, while the 10-Year Bond yield ended at 5.04%, down a sharp .12 basis points on the day.

Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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