There are some things in life that I find perpetually puzzling. It eludes me why anybody cares in the slightest about any of the Kardashians, for example, and why is bacon packaged in such a way as to make getting to it a major undertaking? There are also some more substantial, or at least relevant, things that puzzle me, such as why natural gas futures occasionally spike to crazy highs then immediately drop back. In all these cases though, I have learned to accept the inexplicable, adjust, and learn what I can. I pay no attention to sites like TMZ so as to avoid Kardashian-related news, always reach for scissors when attempting to open bacon, and look to past action rather than logic to predict moves in natural gas.
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Doing so in this case indicates that we can expect gas futures to drop even further from here before too long, even though logic suggests otherwise.
Let's look at the logical case for moving higher.
Prices have already fallen over forty percent in a few weeks, but seem to have found a bottom and have been grinding upwards for a few days. To me, that is normally a buy signal as a continued retracement and accelerated move up would, in theory, be most likely from here. That is what happened in February of last year, but that followed a much less dramatic spike than the most recent one. To find more similar patterns we have to go back to the mother of all spikes in 2008, or the jump to over $6 in early 2014.
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As you can see from the chart above, in both those cases the next move after the spike was a big drop past the starting point for the move up.
Normally, that wouldn't be particularly relevant to the current situation, and would serve as an example of a something that people frequently get wrong about chart-reading. They look only at the pattern and ignore much more influential fundamental conditions. Certainly, the 2008 drop coincided with the biggest recession in decades, but it continued through a couple of years of strong recovery in 2010 and 2011. The 2014 drop came in better economic times and when regulations were being passed that hastened the transition to natural gas-powered electricity generation, increasing domestic demand.
Demand conditions, therefore, don't seem to be a big factor in natural gas pricing over time. Right now, U.S. exports of LNG are building and more capacity for liquefaction and transportation of LNG are expected to come on line this year. Exports should therefore continue to grow, and no matter the current administration's love of coal, domestic demand continues to increase.
The frequency and nature of the spikes, though, with their rapid returns to the mean and subsequent further falls do lead to one logical conclusion. When prices jump, supply can be increased rapidly. In some ways that should come as no surprise. A large percentage of natural gas extracted from oil wells has always been either burned off or returned underground, as storage and transportation costs made its sale uneconomical. When prices suddenly double or more though, that dynamic changes. In addition, extrapolating logically from the chart, that increased supply is not as easy to turn off as it is on, resulting in retracements that overrun.
The pattern of higher highs and lows that we are in now makes the timing of a short trade tricky, and the volatile nature of natural gas makes it no sure thing, regardless of past tendencies. We could continue to bounce for a bit, but when that pattern is disrupted, and with appropriate stop losses to limit risk, positioning for further declines in natural gas looks like the high percentage trade.