Occasionally, Natural Gas Tortures the Bears: This Is One of Those Times

If you pick up a paper (or pull up a publication on your tablet) Thursday morning you will likely read about the natural gas rally that occurred in anticipation of the upcoming cold season and what are deemed to be tight supplies. However, in our view, the better explanation is less complicated: There were too many bears holding short futures contracts or short call options. In true 2021 spirit, the natural gas market has endured rare fundamental events causing speculators and end-users to panic buy. The first was an unusually hot summer leading to increased demand, but the excitement was topped off by Hurricane Ida, which caused supply disruptions. Unless this winter has something fierce in store for us, the market is overpricing demand at current pricing. By us I mean the East Coast and Midwest; in Las Vegas, we almost use more natural gas for barbecuing than heating our homes during the winter months. Fundamental Backdrop According to supply-and-demand data gathered and organized by the EIA (Energy Information Administration), the U.S. is producing roughly the same amount of natural gas as it has been in recent years. This is the case despite a relatively low but increasing rig count. Drillers have been progressively favoring horizontal drilling over directional and even vertical drilling since fracking became prevalent in 2014. This enables drillers to be more efficient and, therefore, capable of supplying the market with fewer rigs. While production is healthy, supply has drawn down (mostly at the hands of mother nature). The EIA graph, below, suggests that gas storage is running a little above the minimum five-year average at 2,871 billion cubic feet (Bcf). This is significantly below the 3,450 Bcf in storage last year and the five-year average of 3,093. Nevertheless, as we learned with crude oil, lumber, and even the grains in 2021 -- when commodity prices are historically high, supply always follows. It is a matter of when, not if. In addition to the fundamental stories supporting gas, which include weather but also entail the big picture premise that liquified natural gas is becoming prevalent at a time in which European gas is quadruple the price of natural gas in the U.S. Speculators Were Too Short Aside from a few temporary rallies, the path of least resistance in natural gas has been mostly lower since fracking took hold of the industry. As a result, large speculators have gotten into a habit of being complacently bearish in natural gas. In 2018, we witnessed a large, well-known, and mostly respected managed futures program blow up dramatically as natural gas exploded in price from about $2.70 to $4.80 in a matter of weeks. A handful of weeks later, gas was back under $3.00. Sadly, the managed program was forced to exit bearish positions, mostly short call options at various strike prices, at substantial losses before prices retreated to normalcy. We must wonder if we are seeing something similar unfold again in 2021. Even if it was not a single large fund or trading program that found itself in trouble, it is clear deep-pocketed speculators likely did. The COT (Commitments of Traders) Report issued by the CFTC, has depicted a market trading at lofty prices at a time in which speculators are heavily short. In other words, it was likely that most of the selling had already occurred as prices moved into the high-$3.00s. When prices moved comfortably over $4.00 there were not enough bears with dry powder to sell into the rally in any meaningful way. This created a vacuum sucking prices higher. Eventually, the shorts began to cover their positions (by buying futures). A break above $4.20 seemed to be the last straw for those bears holding out for weaker prices. At that point, traders were forced to buy back their positions to alleviate emotional stress, meet margin calls, preserve capital, or all of the above. As we can see in this COT chart, above, gas prices are generally much lower when large net short positions accumulate. On previous occasions, the short squeeze that came with the market getting too far over its skis resulted in a move from a trough to an unsustainable rally. On this occasion, the short squeeze appears to have begun at just over $4.00 in gas, or at least near $4.20. Thus, although this squeeze will likely be temporary and has matched the 2018 highs, there is a chance it gets even more out of hand simply because it started at what were already high prices. In 2014, a short squeeze moved gas to $5.75 on an initial run and after a pullback, the market rallied to $6.50. Again, this move was temporary; prices retreated under $4.00 just as fast as they had rallied. They don't call natural gas the widow maker for nothing. $5.00 Is a Significant Pivot Price for Natural Gas We aren't convinced the current rally will last. As we have mentioned on multiple occasions this year, commodities are capable of stunning rallies, but they rarely hold. Throughout history, the cure for high prices has always been high prices. We suspect U.S. shale producers will be excited to bring additional product to the market. That said, commodity markets don't follow rules, expectations, or logic. Instead, their value is derived from the emotional actions of human market participants. With this in mind, we are paying attention to the $5.00 area. It will act as a significant pivot price. If prices close the week below $5.00, we expect a swift downdraft. Yet, if we see a close above $5.00 Thursday, or more importantly on Friday, the bulls will be targeting the 2014 highs near $6.00 to $6.50. In summary, it is foolhardy to try to put a cap on a runaway natural gas market. The rally will go until the last of the under-capitalized or weak-handed bears are squeezed out. Unfortunately, that is the modus operandi of the gas market. If you are long the market, be sure you are protecting profits. If you are short, I hope you are hedging aggressively. In an earlier newsletter, we suggested natural gas call ladders, the direction of the trade was accurate, but the pace and rate of change were underestimated. We have been working on keeping clients delta neutral or slightly long with futures (large and mini-sized). When markets are unruly, the goal is to not lose your shirt.

Occasionally, Natural Gas Tortures the Bears: This Is One of Those Times

They don't call natural gas the widow maker for nothing.

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