Is Natural Gas Poised To Rally?

Since the wild ride at the beginning of the year ended when the $2.50 support held, natural gas futures have been relatively calm. We have seen a much more manageable, if less exciting period of around three months during which prices have settled into a gently sloping upward channel. That relative calm, however, could be about to end.

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A week ago, the main Henry Hub natural gas futures contract, NG, broke out of that channel to the upside, only to fall back into it almost immediately. Over the last couple of days, the top of that original channel has once again been challenged and if we hold above it this time a major short squeeze that sends NG much higher again looks likely.

Of course, even if the technical picture looks bullish a sustained move up is only possible if the fundamentals of the market give a reason for prices to rise, and that looks to be the case given the disparity between perception and reality when it comes to gas.

The perception has, for quite some time, been that the new wells coming on line as a result of oil's sustained climb would result in massive increases in the supply of gas that would inevitably depress the market. The reality, however, is that once seasonal changes are factored in the glut of natural gas is now squarely in the rear-view mirror. Stockpiles are now over thirty percent below their level at the same time last year, and over twenty two percent below their seasonally adjusted five-year average. Given that simple fact, if demand beats expectations by even a small amount a significant pop in natural gas will result.

It is worth bearing in mind that that demand growth doesn't have to come from the U.S. The huge and rapidly growing demand for U.S. liquified natural gas (LNG) from Asia in addition to exports via pipeline to Mexico and Canada are being felt much quicker than most analysts predicted and are now expected to grow even more rapidly over the next few years. To be fair, the prediction that natural gas exports would be a game-changer for the industry has been around a long time, even as prices have dropped, but there is now evidence that the prediction is coming true.

For traders and investors, the next question is how to play this move if you believe it is coming. The degree of leverage involved in the futures market makes it unsuitable for long-term positioning, and ETFs that track the commodity, whether leveraged or not, offer reduced returns after management and maintenance costs. For positions designed to be run over months rather than hours or days, therefore, finding a stock that will benefit from the move makes more sense than trying to structure a direct play.

The obvious choice, given the role that exports look set to play, is Cheniere (LNG). The problem is that, as I mentioned above, the jump in exports has been expected for some time, and, as also mentioned, LNG is the obvious play to benefit from that scenario. As a result, LNG's chart looks like this, and the stock has a forward P/E nudging 30.

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I would rather look for something that has more upside potential, even if it means taking on more risk; something like Chesapeake Energy (CHK). Yes, I know that they have been struggling to shore up their balance sheet, but a current ratio of 2.69 suggests that they are succeeding. Still, worries about that pushed the stock so low that even after a recent pop the forward P/E is barely over 5 despite YoY quarterly earnings growth of over fifteen percent based on last quarter's results.

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So, despite the recent gains, CHK still looks cheap on a relative basis. From this point, every few cents increase in natural gas puts the existential fears that dragged the stock so low earlier this year further behind us, which makes a major drop back in the stock unlikely even if commodity prices falter. Buying here with a stop just below $4 and the intention of holding for the long-term looks like a good trade.