Natural Gas - Down and Out and Unloved
By Frank Barbera CMT. August 4, 2009
Over the last few weeks, we have tried to shine a spotlight on some corners of the market --which perhaps, have been overlooked or ignored by investors who have once again trampled thru the doors in the mad dash for Tech stocks. Not that we have anything against Tech stocks per se, (although we would not hesitate to point out that Tech valuation multiples are expanding to lofty levels), but in their stampede toward Tech, new Tech investors at this time would seem to be throwing a bit of caution to the wind. How about a peek in some other direction, possibly where earnings are generally a lot more consistent, and where valuations now reside at near decade lows, rather than near decade highs? Impossible in this over-extended market? Well, actually, not at all. Take Natural Gas for example. It is derided and hated beyond all measure, to call it ‘unloved’ as we did in today’s title is probably putting it lightly. Of course, as a commodity investment, Natural Gas has been expelling some very poor results over the last 12 months, one could say, flatulent results, or that investing in Natural Gas has been one big ...well, you know what I mean.
Since peaking near $13.33 in early July 2008, the Great Credit Collapse has sparked a Natural Gas deflation to the tune of -71.26% with current prices near $3.83. For Natural Gas, these are in fact the lowest prices seen since December 2002, over six years ago. What’s more, going back over the last 15 years this is the second largest, most compact decline in Natural Gas on record. The two largest prior declines were seen from December 2005 ($14.47) to September 2006 ($4.57), a decline of –68.91%, and from January 2001 ($8.80) to January 2002 ($1.85), a decline of 78.97%. This fact alone makes a closer study of Natural Gas worth the time as a contrary investment play.
Of course, just because an asset has had a big decline and is out of favor does not necessarily mean that the investment is timely. Sometimes, out of favor assets can languish for months at a time and methodically wear out investor patience. In the case of Natural Gas supplies are bloated, and unless the forthcoming winter is especially cold, prices may not react all that much on the upside. Speaking of supplies, we navigated our way over to the Energy Information Administration (EIA) website and found that current Natural Gas Underground Storage totals 3,023 billion cubic feet as of the week ended July 24th. That was a gain of 71 billion cubic feet from the week before. Typically, between July and mid November (the start of winter in the US) Natural Gas stockpiles are on a steady build. Depending on how early winter begins defines the start of the storage draw down phase. On the surface one might be led to believe that prices are always soft during this time period as inventory accumulates. Surprisingly, that is not the case.
In preparing this piece I went back to early 1994, the earliest data available on the EIA website, and plotted a least squares regression line through the EIA Storage data. I then created a regression channel plotting a trendline plus and minus one standard deviation above and below the middle line. With total storage at 3,023 billion cubic feet the week of July 24th, the upper trendline came in at 3,197 billion cubic feet with that upper line rising about 1 point per week. In my study I noted that once underground storage has moved all the way up to the upper regression channel line, prices have had a notable tendency to find a high level of stability, or even start advancing flat out. At the present rate of inventory accumulation a reading near 3,200 billion cubic feet should be achieved within the next two to three weeks. At the very least, even if final price lows are not in place, Nat Gas usually will try a sizeable short covering rally and then follow up with a retest of the lows (a secondary decline) as inventories approach the high end of the range. Put simply, prices normally begin to ‘dig in’ as the market, like all markets, tends to be forward looking, and by August is starting to focus on Hurricane season and the onset of winter. For Natural Gas, there is an argument that a lot of the bad news about high inventory may already be baked in the cake as going back over the last 15 market episodes, prices had seen their final lows in 11 of 15 instances as inventories pushed up to the upper regression trendline.
Above: Spot Natural Gas with EIA Underground Storage Estimates
In addition to the potential ‘discounting in’ for much of the ‘bad news’, Natural Gas is also historically oversold. In the chart below we plot the annual rate of change for Natural Gas, which is currently just starting to improve and is coming off some of the most extreme values ever seen. Typically, following these kinds of excessive oversold values, prices have a marked tendency to snap back and that implies a bounce could lie directly ahead. In fact, as we pen this article on Tuesday morning, Natural Gas prices have opened smartly higher, suggesting that perhaps an important ‘turn’ could be in the early stages.
Above: Spot Natural Gas (weekly) 1994 to present. Bottom: Rate of Change Gauge
Of course, for most of us, taking on the kind of leverage often seen in the futures market has very little appeal. Fortunately, for those who are adept at timing, there are now ETF’s which can help an investor buy the actual commodity without having to buy a futures contract. Over the last two years, the US Natural Gas Fund ETF, symbol UNG, has been perhaps the most widely traded of the Nat Gas ETF’s. Unfortunately, the tracking error on the ETF has been substantial as the contract roll over issues have hampered its performance. That said, all is not lost in the Nat Gas ETF arena. A newer ETF, the Claymore Natural Gas commodity fund in Canada, symbol: GAS on the TSE, seems to be doing a pretty good job of tracking the underlying commodity. While there are never any guarantees this will continue, and investors/traders are counseled to do their own homework, the price action thus far seems a reasonable fit. To that end, I show the updated chart below and accompanying it, the 14 day RSI. Quite the thing of beauty with a sprawling positive divergence both at the June low and the July lows. While pointing out the encouraging nature of the overall Natural Gas trading pattern, I would hasten to point out that the market did ‘gap’ higher this morning, and in all likelihood, could ‘come in’ and fill the gap at any time. Caveat Emptor.
Above: GAS on the TSE, an ETF that tracks Nat Gas, with 14 day RSI Momentum Gauge
Of course, investors can also derive solid profits from a rise in the price of Natural Gas by playing the Natural gas producers. When it comes to the large cap producers, thus far these stocks have been held back by the weakness in Natural Gas and have underperformed both the broad stock market and the large Cap energy producers. In the chart below, I plot the relative strength ratio of Natural Gas producers versus the S&P (bold) and the same ratio for Oil Stocks versus the S&P. Thus far, large cap Natural Gas has been the weak sector within energy.
Above: GST Unweighted Index of Large Cap Natural Gas stocks 1989 to present
As can be seen on the longer term chart shown above, large Cap Natural Gas stocks are still in the lower portion of the long term rising channel and while they are near some price resistance, could be well positioned to break out in the months ahead. Note: in the near term, I do expect a 2 to 3% set back on the S&P toward the 975 to 980 area, and these stocks can be expected to dip a bit in sympathy. In screening the large cap Natural Gas stocks, I found a number of names selling at very cheap Price to Free Cash Flow multiples, with stand outs like Ultra Petroleum (UPL) and Encana (ECA) appearing on the fundamental yardsticks for value.
|Cap||Free Cash Flow|
Even more opportunity may exist in the months ahead for investors with a keen sense of value in the Small Cap Energy sector. Here we find a lot of quality names still hovering near multi year lows. Our GST Index of Small Cap Energy stocks (50 names) is back to 2003 price ranges, and is just now showing the first signs of life after a long staggering decline.
Above: GST Small Cap Index of Oil and Gas Producers
Above: Relative Strength Ratio of Small Cap E&P to S&P 500 with 200 day Avg. and bands.
Over the last few days, the Relative Strength Ratio of Small Cap Energy ($5 Billion and under) has managed to move above the 200 day moving average. While this is only a tentative beginning and prices may pull back, it does suggest that a period of stabilization has been reached, with many of the stocks in this sector in well established basing patterns. As with the large cap Natural Gas stocks, many smaller cap energy names now sport remarkable valuation metrics, with the table below providing a quick snap shot of some names between $100 million and $5 Billion with positive Price to Free Cash Flow multiples. These are companies that have lots of financial staying power, something highly recommended for the kind of trying economy we now confront.
|Cap||Free Cash Flow|
|Plains Exp & Prod||PXP||3400.00||49.81|
|St Mary Land Exp||SM||1500.00||222.09|
All in all, a key aspect in evaluating emerging junior energy producers is (a) the necessity of positive cash flow, and then secondarily (but of large importance as well), the prospects for future growth with advance stage development projects lining up in the pipeline. Our philosophy is simple - the more tickets turning in the lottery bin the better, as often we like to see a company with current production and at least one advanced stage project, and two to three additional earlier stage development projects in the works. For companies without positive cash flow, any downturn in capital markets could mean an end to easy access to capital markets, and as we saw last year, when the capital spigot gets turned off, bad things happen to the share price. Stick only with names where they can be self-funding, and where access to capital markets is a ‘choice’, not a necessity. That’s all for now,
© 2009 Frank Barbera