Why There’s More Upside For Natural Gas

December Natural Gas futures rallied to its highest level since July 1 before posting a dramatic and potentially bearish closing price reversal top on the daily chart on September 22. Bullish factors continued to support the market this week. These included hot temperatures in the U.S. that have contributed to a natural gas power plat burn, evidence that the year-over-year supply glut is disappearing and the threat of a massive short-covering rally.

The week began with a strong upside bias because of a potentially bullish U.S. Commodity Futures Trading Commission Commitment of Traders report released on September 16. The report showed the shorts covered about 28% of their positions since the last report, closing the previous week with 173,728 open positions. This was also the smallest short position since 2014.

The recent strong closes had put the market in a position to take out several previous tops, setting up the possibility of a breakout to the upside if the buyers were able to overcome the shorts. And that they did on Tuesday, September 20, when a massive short-covering rally took out the previous tops. Although the move looked dramatic on the charts, it was generated by shorts getting out of the market rather than fresh longs entering the market.

This type of breakout move is usually the weakest because it signals to traders that buyers are not willing to pay up for natural gas, and would rather wait for a pullback. The best breakout rallies occur on rising volume and when enough buyers come in immediately to defend the breakout.

This did not occur in the natural gas market after the breakout and the market began to weaken into Thursday's close. The market is in no danger of turning the main trend to down, but it is set up for a meaningful pullback on the daily chart.

Next week is going to begin with December Natural Gas prices in an uptrend, but controlled by downside momentum. This will mean that trend traders will be better off waiting for a break into a value area, rather than chasing the market higher.

Although summer may be coming to an end and temperatures may return to seasonal levels, the market is likely to still maintain its upward bias. This is because the oversupply situation that had plagued the natural gas market for years was reduced at a strong pace throughout the summer due to increased demand from the power plants.

Last week's CFTC COT report also revealed that hedge funds held the largest bet on rising prices in two years, as less gas has been placed into storage ahead of the winter months. The price action suggests that this rally could continue over the near-term, but this is only likely to happen if the hedge funds continue to buy the market on the pullbacks into value zones.

From the fundamental side of the equation, the picture looks good. Traders are expecting that injections over the course of the next few weeks will be weaker than in previous years. This is encouraging for the bullish traders because it probably indicates that producers have scaled back production due to the historically low prices.

Additionally, the draw down in supply likely means that investors will not have to worry about exceeding storage capacity and can focus more on the traditional supply/demand fundamentals.

Technical Analysis

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Technically, the main trend is up according to the weekly swing chart. This chart is comprised of a series of higher-tops and higher-bottoms. As long as we maintain a series of higher-tops and higher-bottoms, the strong uptrend will continue. The chart also shows there is strong evidence that investors are buying the dips. This is sign that real buyers are coming into the market and that the rallies aren't only being fueled by short-covering.

If we look at the range since June 2015 to present, or $4.535 to $2.370, we can see that this range's retracement zone is $3.453 to $3.708. This zone is the primary upside target.

On the downside, we have a support zone at $3.064 to $2.992, however, I will question the upside potential of this market if $3.010 fails as support.

Conclusion

Despite the selling off on the daily charts on September 22, I'm going to maintain my upside bias because of the strong uptrend on the weekly chart.

My position is supported by the strong hedge fund presence on the long side of the market. And on the possibility we will start the winter heating season with supply lower than it was a year ago. According to Platts, total stocks continue to trend well over 3 trillion cubic feet, and remain above last year and the five-year average. However, this excess support could be used up fairly quickly if winter comes early, or if an extremely cold winter leads to a major drawdown.

At this time, it is suggested that investors start watching the longer-term forecasts for guidance because the natural gas market is set up for a strong rally. Based on the cold winter of 2014, we could easily draw down a trillion cubic feet fairly quickly if cold temperatures are severe and lingering.

Look for a 2 to 3 day pullback at the start of next week then start watching the price action and the CFTC reports to determine if hedge funds are increasing their long positons on the breaks into value areas. Be careful buying strength on low volume. If you're going to buy strength then make sure you do it with strong buying volume behind you.