Hot Market in Cool Weather

These have been tough times for the perma-bull commodities investors.  It’s still true that if you’ve been a steady bull on commodities over the past couple of years you have done extremely well despite the recent volatility.  It is also probably true that if you stay long the commodities, you’re investments will be worth more by this time next year.

The problem is that the sit and hold strategy isn’t for everyone.  There are vast amounts of ways to invest in financial markets, and I’m not going to tell you that one is better or worse than another.  What I will tell you is that all forms of commodities investment requires period of bringing new capital to play.  I believe that in one particular market, the time to assign new capital has arrived.

Too Hot to Handle
I am talking about natural gas.  Natural gas was recently sold off with the rest of the commodities.  In fact, the pull back in natural gas was very violent as it lost some 37% of its value.  This sort of price action is to be expected considering gains in excess of 80% prior to the pull back.  Remember, they higher they go the harder they fall.  It doesn’t mean we have entered a bull market.  It just means that higher levels of volatility have shown themselves, and the waters will only get more turbulent going forward.

I’m not trying to intimidate you.  I just want you to understand that the price swings, both up and down, going forward are going to be swift.  There will be a lot of profit opportunity on the way, but we will also have to try and stay conservative on the way, as to not get burned.

Reasons Natural Gas is Heating Up
I would first like to discuss some of the fundamentals of this trade.  Many would ask if this is a play on an energy rebound, why not buy oil or reformulated gasoline?  The answer to this question is fairly simple. 

Oil and gasoline prices may or may not spike in the very near term.  Both were strong in today’s trading, but I don’t think a rally in either would be sustained.  I see a little more downside risk in oil prices, but I am not looking for specific numbers.  It is a seasonal play for me.  I fully expect oil prices to bottom out in the latter months of 2008 before beginning another record setting run in the beginning of 2009.  I will be looking for something similar to the trading that started in early Jan. of this year and ended during the spring.

In the mean time, I don’t want to be long oil.  Instead, let’s look at the other side of the seasonal trade.  There is much more natural gas demand in the winter.  Especially considering the rather mild summer we had as many natural gas power plants work on the margin.  Natural gas is a huge part of heating America during our winters.

So if one feels so inclined to do so, a long natural gas, short oil spread could be considered as a simple seasonal trade in the energy sector, but let’s take a look at the naked long side of the trade.

Charting the Overheated

Here we have the continuous natural gas contract.  The first thing that jumped out to me is exactly what we have already talked about.  When a commodity gets extremely overbought, as shown by the extreme divergence of the 50 day and 200 day MAs, it takes a sharp correction to right the ship.  Well, that’s exactly what we got.

The second item to note is the fantastic support shown at 8.20, which has already acted as a brief touch of support.  Correlating with that are some other signs of a possible bottom forming.  The MACD is really rounding out after falling off a cliff with no hint of recovery along the way.  In fact the MACD has just barely crossed over into bullish territory.  This is not a screaming buy signal by itself, but it is another piece of the puzzle.

Looking at the DMI, we are also seeing a change in trend.  After a period of tremendous bearish divergence, it appears to be beginning a bullish convergence.  If the trend continues, a bullish crossover, and confirmed buy along with the MACD.

This appears to be a point where we could potentially be nearing a bottom.  Another reason I am willing to stick out my neck and call a bottom here is that options expire Aug. 15th.  It would be then that I might consider pecking at setting up a long position in natural gas.  As I said, this could be a fast moving trade.  If that makes you uncomfortable, remember that you could potentially spread this long natural gas position against a short oil position as a hedge.  This reduces your risk reward scenario.

Two Hot Nat Gas Plays

I’m going give you two potential ways to play this market.  The first is the most conservative.  You could buy the United States Gas Fund (UNG) which is the natural gas ETF that follows the spot price.  This reflects the futures market extremely accuracy, while allowing you to play with a non-leveraged position.  The downside of this play is the tax implications.  UNG is taxed at a higher level than a regular equity.  An IRA of sorts would be a great place to make a trade of this nature as it exempts you from the tax implications.

For those of you with a desire for a little higher risk reward scenario might be interested in this next play.  I am talking about a natural gas producer by the name of Chesapeake Energy  (CHK).  This is not necessarily as your junior or intermediate producers, but it is very solid.

Many of you have probably heard of Chesapeake, and I don’t want to get too much into the details, but I do want to explain a couple brief things.  I truly believe that CHK has some of the best natural gas traders in the world working for them.  The ability that these guys have to hedge and re-hedge themselves is second to none.  It’s that sort of talent that is more essential than ever given today’s financial climate.

The second reason is something that is very important to me.  Aubrey McClendon, co-founder, Chairman of the Board, and CEO, has literally been buying as many shares of Chesapeake that the rest of the board will let him.  He has invested a mass amount of his own wealth within the company, and he may be the biggest believer in his company’s potential.  I LOVE to see management putting their money where their mouth is.

Nicholas Jones
Analyst, Bourbon & Bayonets