Thursday, September 17, 2009

Explaining the Irrational Exuberance of Natural Gas: De-constructing a Dead Cat Bounce

Since the last time I wrote an extended piece on this blog site, the market has moved significantly (56% higher than the low placed about 10 days ago). The market didn’t see this rally coming. And, searching for answers, analysts attempt to attribute a particular fundamental to what has transpired over the last 10 days.  I don't think what has gone on is "fundamental" - as in supply and demand -  at all.  In my opinion, it is a dead-cat bounce.

This rally was a one of human emotion. It was caused by a blend of greed (or complacency) and fear. As the market fell, the front month price fell more significantly than the out months. This Rigzone article discusses that the steepness of the term structure contango was a four standard deviation event - meaning that the difference between the front month price and the out-month price is about as significant as it ever gets.  Considering this, many shorts entered the market in the front month, knowing that the roll from month to month would credit their position and the term-structure "contango" would work in their favor.

These speculative positions in the market were short in the face of the lowest gas prices in a decade. But they were making money, so they remained short. And then….the market rallied 15 cents. Some of them – the recent entrants – were then holding losing (unprofitable) positions. Trading with a stop-loss discipline, they said “enough is enough” and blew out – they BOUGHT. This pushed the market higher, and took even more trader's positions into negative equity situations. As nervous or disciplined investors, THEY headed for the exits, too. They BOUGHT. And this forced the market higher still. At this point the market had rallied maybe 50 cents. At this point, the market move started to attract the hot money that looks for trends with velocity. This money wants to jump on the trending market’s bandwagon and ride that bandwagon for a significant and quick profit. So…the move higher created by nervous investors exiting shorts is exacerbated by new “hot money” longs. The market has ingested these new positions by adjusting price, and by now it is more than a dollar higher. we stand. Such is the status of the natural gas market on September 16th.

Old trader types say “if you drop it far enough, even a dead cat will bounce.” It is because the steady move lower allows folks to get out of position – to blend greed and complacency and find them in an unmanageable position should the market stop behaving in such a convenient and predictable trend. I perceive the recent strength as a dead-cat bounce and I look for more downside as the market adjusts from the exuberance of the last 10 days.

Let’s not forget: Natural gas storages are full. Rig counts are down, and gas production numbers still relatively flat to prior years. There are new and significant sources of shale bed supply that are shell-shocking the market to a new reality, and the demand base is slow to evolve to these breakthroughs. These are all short-to-intermediate term bearish considerations.

As I wrote in my last market commentary extended post, the last two times that natural gas prices have been this cheap, things turned around quickly. People that actively manage energy price risk should consider buying a piece of product at historically low prices if it fits their needs.  And while we all get nervous in this situation, after the market rallies 56% off the lows, it seems reasonable to wait for prices to adjust after such a dead-cat bounce.


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