Will Expected Retreat Segue Into Seasonal Trend?

Natural gas prices have slumped in recent weeks, despite the fact that, over the last three months, there's been a huge run up in price due to the coldest winter in decades, writes MoneyShow's Jim Jubak, who explains where prices may be headed next.

Will the expected retreat from peak prices for natural gas—a result of the intense cold that the US saw in January—segue into the normal seasonal trend that produces an annual bottom in natural gas prices during the shoulder season of May/June?

That possibility suggests that this isn't the least risky moment in the near term to be buying the shares of natural gas producers—even if, like me, you're bullish on the long-term trends for this commodity.

I use United States Natural Gas Fund (UNG), an ETF that follows the Henry Hub price of natural gas in the United States, to track trends in natural gas prices. From a low of $17.09 on November 4, United States Natural Gas climbed, first to $19.69 on January 9, and then to $26.73 on January 29. Total gain 56.4%.

For the last two weeks, though, natural gas prices have slumped. From January 29 to February 10, the ETF has dropped 15.2%. (Natural gas rallied big time yesterday, February 11, with the ETF rising 6.7% at the close.)

The huge run up in natural gas prices over the last three months has been a result of a higher than normal spike in heating demand, thanks to lower than usual temperatures. The amount of gas in storage has dropped, as demand has soared, in what has been the coldest winter in decades. Utilities and industrial gas users have drawn down more gas than stipulated in their long-term contracts and they have been forced to buy gas on the spot market. In addition, the extremely cold weather has recently reduced natural gas production, with US natural gas output running about 0.8 billion cubic feet per day lower than the 30-day moving average.

Under those conditions, natural gas prices should have moved higher and they did.

In the last week (before yesterday anyway), though, traders have started to wonder how long the trend toward tighter supplies and higher prices will run. Last week, a report from the Energy Information Administration said that natural gas inventories fell by 262 billion cubic feet. That kept the supply trend pointed in the right direction, but the drop was still less than the 270 billion cubic feet decline, forecast by analysts surveyed by Reuters.

A market up 56% in less than three months doesn't need much of a reason to sell off. And traders who caught the move have been taking profits recently.

It's certainly too early to start factoring the May/June seasonal slump in natural gas demand into natural gas prices-but it's not too early for traders to start factoring the drop in demand during what is called the shoulder period, between the high demand for natural gas during the winter heating season, and the high demand for natural gas during the summer air conditioning season, into their trading strategies. Storage levels typically peak in November/December, ahead of winter demand, and then bottom in May. The rate of draw down from storage starts to slow well before that May bottom.

I don't think the May/June shoulder is a compelling reason for traders to sell positions in February. But that 56% gain, from November to February, does make profit taking very attractive right now and it does lower the incentive to put on new positions after a drop of only 15%.

The big question in my mind is whether a 20% or 25% drop would bring traders back into the market in an attempt to play natural gas one more time before shoulder season, or whether most traders will be content to sit out the next few months and wait for the seasonal bottom. Is yesterday's surge, the beginning of a tradable move, or simply a one- or two-day wonder?

If you're not a short-term trader, in my opinion, waiting for the seasonal bottom to rebuild any positions that you sold recently, in order to take profits (such as by selling part of a position in Jubak's Picks portfolio member Chesapeake Energy (CHK)) is the most attractive play on a risk/reward basis.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did own shares of Chesapeake Energy as of the end of December. For a full list of the stocks in the fund, see the fund's portfolio here.