Financial market prices are moved by participants anticipating changes in supply or demand, the fundamental forces of economic activity. Prices move based on what is expected to happen at some point in the future.
This is why markets often seem to move in the opposite direction many investors expect. The anticipation of a sharp change in supply or demand is often much more powerful than the actual confirmation of the change. The old market saying "Buy the rumor, sell the fact" is a great way to think of this concept.
Nowhere is this better demonstrated than in the commodity markets. Rumors and forecasts of supply disruptions due to weather, government action or a host of other factors can send short-term commodity prices skyrocketing. Next, after the disruptive event occurs (or doesn't), prices fall back to the norm. (Regular readers of Dave Forrest's Junior Resource Advisor are kept abreast of potential changes in investors' perception of supply & demand in the commodity markets.)
Recently, this is being witnessed in the natural gas market. Forecasts and the reality of an ultra-cold winter in the northeastern U.S. have pushed the spot price of natural gas prices from $3 per million British thermal units (BTUs) to just over $5 per million BTU in the past six months.
Prices plunged to a low just below $2 per million BTU in the first few months of 2012 before slowly climbing higher despite a known supply glut.
Horizontal drilling (aka fracking) has increased natural gas supply dramatically. Rita Beale, senior director of power, gas, coal, and renewable energy for research firm IHS Global Insight, told CNBC, "We now have knowledge and comfort that we have an incredible resource base: technically recoverable resources of 3,000 trillion cubic feet (Tcf)." She went on to say, "We have 900 Tcf of gas that can be recovered for $4 or less."
Basically, this means that natural gas prices are expected to remain in the $4 to $5 range over the next 20 years. It's important to note that Beale made clear that there will be price spikes and that her projection is a long-term average. Interestingly, there is such an oversupply of natural gas slated to occur that the United States is making plans to start exporting the commodity in 2019.
Let's take a closer look at exactly what is happening now in the natural gas market. Prices spiked higher to just above $5 per million BTU over the past several months, marking three-year highs. Ultra-cold weather in the United States points to increased demand of the heating fuel. This demand resulted in natural gas stockpiles to decrease 13% below their five-year average.
Investors and hedge funds overreacted to this short-term rise in demand without looking at the long-term picture for natural gas. In fact, bullish bets on the commodity by hedge funds hit an all-time record on Jan. 21, according to the Commodity Futures Trading Commission. This is what has pushed prices to the recent highs. It is nothing but a skewed perception of supply and demand based on ever-changing short-term numbers and the herd mentality of investors of all sizes.
This means that I think the top is in or near in natural gas for quite some time. Taking profits or shorting the commodity makes sense right now.
Risks to Consider: The old saying "Markets can remain irrational longer than you can remain solvent" is 100% accurate when dealing with commodities such as natural gas. Despite strong evidence that a price move is overdone, prices can always move further than anyone expects. This is why, even with top-notch research, stop-loss orders are critical when trading.
Action to Take --> As long as natural gas stays below $6 per million BTU on the daily close, I firmly think that it will move lower over the next 12 months. Investors who wish to play the potential downside move in natural gas can short exchange-traded funds (ETFs) such as United States Natural Gas Fund (NYSE: UNG). For those who can't short directly in their account or simply prefer not to, inverse ETFs such as ProShares UltraShort DJ UBS Natural Gas (NYSE: KOLD) are perfect.
However, be aware that this inverse ETF is double-leveraged, which means it is designed to move twice as fast as the actual underlying commodity. This can be dangerous if the price moves in the wrong direction. (My colleague David Sterman examined natural gas plays like these earlier this week.)