Natural Gas Mean Reversion?

Over the weekend I tweeted that I liked Natural Gas on a closing basis above $2.75 and got a few questions asking for an explanation. Here is my reasoning.

As with any financial market prediction, a timeframe needs to be defined. I expect this trade to play out over the next 3-6 months and therefore, by my definition, it is not a long term investment.

A look at a 10 year weekly bar chart of natural gas with nothing more than a simple moving average and a momentum indicator makes it clear why this is just a trade.

Natural Gas Weekly

  1. The 200 week simple moving average is declining.
  2. Momentum continues to confirm new lows in price and recently hit oversold conditions.
  3. Prices undercut the August-September 2012 lows and closed higher to confirmed support.

It doesn’t take any fancy system or strategy to see that structurally, Natural Gas remains in a downtrend. With a downward sloping 200 week sma and a lack of any positive divergence in momentum, it is going to be difficult for prices to sustain rallies.

Before I move onto the daily chart to outline the trade, I think it’s important to see what’s happening with sentiment and seasonality.

  1. According to sentimentrader data, public opinion is at lows not seen since May of 2010.
  2. Commercial hedgers are net long roughly 211,000 contracts, approaching the all time high levels of 229,000 contracts that occured in February of 2011.
  3. Seasonally, March – May is the best three month period of the year with returns averaging 4.5%, 1.9%, 3.0% in each of those respective months over the past thirty years.

The combination of large speculator pessimism and aggressive buying by the smart money hedgers as we head into this seasonally bullish period could be a really nice tailwind if price can get going.

Now that I know that structurally Natural Gas is in a downtrend, what does the daily chart look like?
Nat Gas Daily

  1. Prices broke above the 3 month downtrend line.
  2. Prices confirmed a false breakdown by closing back above the previous lows of 2.731.
  3. Momentum put in a positive divergence, not confirming the recent lows in price.
  4. Prices are currently 43.5% below the 200 day simple moving average.
  5. Prices continue to base and close above this breakout area and previous low of ~2.73.

I think prices confirming this false breakdown and positive momentum divergence is extremely bullish. Additionally, prices continue to confirm this support intraday and close higher within what I see as healthy consolidation. With prices being so far below the 200 day, I think this recent price action is the start of a nice mean reversion trade. With all that being said, the best part about this is that I only have to risk 9 cents to participate and am looking at an ultimate price target at the 200 day, near $4.00; a 13:1 risk/reward ratio.

The Bottom Line: I only like Natural Gas on closes above $2.73. If we close below those lows highlighted in gray on the daily chart, there is no reason to be involved on the long side. This recent price action paired with the sentiment & seasonality tailwinds discussed above, suggest that this is a good risk/reward opportunity over the next 3-6 months.

Risk: $.09 as I only want to stay long with closes above $2.73.

Reward: $1.18 assuming we get a mean reversion back toward the 200 day at $4.00.

Risk/Reward: 13:1

Price Targets: Obviously prices will not head to $4.00 in a straight line, so below are important resistance levels that I think will be important to watch as prices move higher toward our ultimate target. If prices fail to consolidate at these levels or show weakness, obviously I’ll have to rethink whether or not the thesis for a move toward $4.00 is in jeopardy.

  1. $3.13 – 2013 support level
  2. $3.37 – Start of a gap fill
  3. $3.62 – Mid December consolidation support level
  4. $4.08 – Support / Resistance level throughout Q3-Q4 2014

Follow me on stocktwits and twitter as I’ll try to update you all on my thesis if conditions change.

As always, if you have any questions feel free to reach out and I’ll get back to you as soon as I can.

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