Time to Consider Oil's Ugly Cousin
By Graham Summers

On Wednesday we detailed three of the largest issues affecting oil prices. To review they are:

1. Geopolitical concerns (Iran, Russia, and Pakistan)
2. Speculation (in July, 11% of oil contracts were controlled by one trader)
3. The over-leveraged financial system.

These three items make forecasting oil prices virtually impossible. Fortunately, oil’s ugly cousin, natural gas, doesn’t suffer quite the same fate.

Natural gas is relatively free of the first two factors—the US produces most of its gas domestically and speculation in the natural gas markets is significantly lower than in the oil markets. However, neither of these stopped natural gas from being brutalized by the third factor: over-leveraged investors.

Natural gas has a lot going for it. Cleaner and cheaper than oil, less politically charged than nuclear power, and located domestically, it’s hands down the most viable choice for long-term energy policy. US power plants know this and consequently have begun switching to natural gas power in droves.

According to the Energy Tribune 90% of the US energy capacity that has been added since 1998 has been natural gasified. Electrical generation based on natural gas has increased 34% since 2002. And several of the US’s largest states—California, Texas, and Florida—are now generating between 40% and 50% of their energy from natural gas

Unfortunately, investors—particularly overleveraged hedge funds—also knew about natural gas’s positive qualities and piled into the commodity. So when natural gas prices began to slide along with oil in mid-July, these guys, terrified of margin calls, issued a fire-sale, pushing natural gas prices down 40% from over $13 to $8 and change. By way of comparison, oil only fell 20% during the same time period.

Natural gas is now significantly oversold, especially relative to oil. Over the last 18 years, oil, on average, has traded at 9.2 times the price of natural gas. Today, the ratio stands at 13: a 13-year high.

Put another way, oil needs to plunge to $72, natural gas needs to rise 50% to $12, or some combination of the two needs to occur to bring this relationship back in line with historic trends.

There’s also a seasonal effect here. Natural gas has put in a seasonal bottom during August-September in six of the last seven years. Looking at the latest monster sell-off, it looks as though this effect took hold earlier than usual this year due to the unwinding of over-leveraged investors.

In addition, the sell-off has also made many unconventional natural gas projects—primarily in Texas, which supplied more than 50% of the increase in domestic production between 1Q07 and 1Q08—no longer economical. Thus, with natural gas today we have the rare combination of:

• A seasonal bottom
• An oversold condition
• A fuel source that is cheap relative to its peers and politically neutral
• The cold season approaching

Be advised, natural gas, like all commodities, is having a volatile time right now. So if you look to invest in this market? or in natural gas stocks? be prepared for a bumpy ride. But I have little doubt that within six months you’ll have turned a tidy profit. And the fundamentals are certainly better than oil.

Best Regards,

Graham Summers

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