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Is $1.61 the End of a Cycle? Is Natural Gas Headed for $2.40? Check Sentiments, Trendlines

Although when natural gas prices traded at 13-year lows of $1.611/MMBtu on March 4 it may have seemed that the industry as we know it may have come to an end, a study of the industry reveals that current low prices, layoffs, and lack of capital investment represent instead the end of a 15-year cycle.

And if the observations of one analyst are correct, $1.611 could be the bottom of that cycle and the start of a near-term price advance, if not a resurgence in capital expenditures, the public favoring investment in natural gas investment vehicles, higher production, and easier credit.

In a technical study of the natural gas market entitled "The Outlook From Here,” Walter Zimmerman, vice president at United ICAP, shows the progression of the industry and how sentiment shifted from a Bubble Peak in 2008 to the current cycle low.

There is little argument of a cycle low. The Federal Reserve Bank of Dallas reported energy sector bankruptcies reached levels during the final three months of 2015 last seen in the Great Recession, as the financial toll from lower commodity prices squeezed oil and natural gas producers (Shale Daily Dec. 28, 2015)

Analysts at Tudor Pickering, Holt in discussions with oil field service (OFS) operators over the past few weeks have found enthusiasm lacking for the near-term. Anyone looking for a silver lining for the U.S. natural gas and oil business should not think it will come from the OFS sector, as management teams are less optimistic than they were even a few months ago (Shale Daily, March 16).

Not only is industry sentiment low, but market sentiment is equally morose as well. Zimmermann utilizes data from Marketvane.net to show how current sentiment fits in a longer term market cycle. "Market Vane sentiment is a contrarian indicator and records unsustainable market extremes. When everyone is bullish, it is time to get short, and when everyone is bearish it is time to get long. Into the $1.611 low, 89% of market analysts were bearish and short,” said Zimmermann.

Zimmermann also contends that the flow of information regarding market moves tends to be self-reinforcing, and just as a market advances, "the news has to be maximum bullish because every day you have to explain what made the market go up again, and again, and again. The same works on the downside. Market Vane is a survey of analysts, and if the analysts are bearish, the CEOs are bearish, the newspaper writers are all bearish, and investors are all short.

"The other narrative here is just how that collective mood creates its own reality. When you are at $15, everyone is thinking $30 natural gas and we are never going to see single digits again. We have a chronic shortage, At the lows, it is just the opposite -- ‘the whole industry is going bankrupt and we will never recover.’

"A lot of really smart people get caught up and swallowed by that collective mood. People can't get out of that collective cocoon of doom and gloom and get so deep in the need to explain the bearish side that you become blindsided to the fact that there is only one way for the shorts to get out and that is to buy. People start buying as soon as the market starts selling off and it stops selling off once you get an extreme of bearish sentiment.”

But prices are only part of the cash flow equation for producers, noted Patrick Rau, NGI's Director of Strategy & Research. "Don't overlook what the impact on technology has had and very likely will continue to have on production costs. If those continue to fall, long-term natural gas prices could also keep falling without necessarily killing producer margins.”

Natural gas is a commodity business, and as such, “it is the closest thing the world has to being a perfectly competitive market. In perfectly competitive markets, producers are price takers. That means they are motivated to lower their costs as much as possible. Modern advances such as hydraulic fracturing, horizontal drilling, and better completion recipes have really helped reduce unit costs, which have enabled producers to accept lower prices and still earn acceptable rates on their invested capital in recent years," he said.

Rau concedes that many producers and oil service providers are struggling to earn adequate returns at current prices, which should lead to a reduction in output that could lead to a reversal in prices in the coming months, even in the face of large U.S. storage balances coming out of a historically warm winter season. "However, any short-term rise in prices does not necessarily mean the end of the long down cycle is near. Prices can continue to trend lower if technology advancements continue to allow finding, development, and production costs to decline."

Sentiment isn't the only indicator prices may be headed higher, according to Zimmermann. Conventional technical analysis utilizing trendlines gives an indication that the market may be headed higher. The trendlines from the market high of $6.493 in early 2014 show a bullish falling wedge pattern. The pattern is bullish because if downside price momentum were being maintained, support and resistance lines would be parallel, and this would be normal downward sloping channel. Each new leg is shorter than the prior leg down, and these shorter and shorter legs reveal waning downside momentum. The market decline is slowly running out of steam.

The wedge pattern, however, shows that this is a big bear trap, and a buy signal is given when prices break above the upper trend line. Currently the downtrend line cuts at $2.110 and $1.95 by mid-April.

Seasonality is also on the side of the bulls. An average pre-season rally in natural gas is 49%, which would take prices to about $2.40.

Zimmermann also relies on retracement analysis to give insight into the market's next move. "My .236 rule of thumb is that when after a major decline a recovery meets resistance into the .236 retracement of the larger decline, then new lows can be expected." The .236 retracement of the decline from $6.493 falls at $2.763.

"The advance [to $2.11, $2.40, or $2.763] is not cast in stone," says Zimmermann.

 "There are some major hurdles that have to be cleared before the bulls are home free and the bears are confirmed stuck. $2.40 is not cast in stone and the bull case is not open and shut."

Market forces are coming into alignment that indicate the $2.40 is more likely than $1.50. "That statement is a ‘Yes, but.’ It's always conditional when you are dealing with probabilities."

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