Natural gas bulls should be patient...Contango complicates the bottoming process.

Contrarian traders are salivating at the idea of getting bullish in natural gas on the heels of one of the largest natural gas collapses in recent history. However, although we agree the natural gas market is in the process of bottoming, we caution that cheap gas prices might get even cheaper before the market stabilizes. Last month our natural gas analysis was featured on the Off the Charts segment of Jim Cramer’s Mad Money TV show on CNBC (click here to revisit), at the time we were suggesting that the natural gas rally would stall and believed that the bulls should start getting interested on a pullback into the mid-$2.00 area. We never dreamt the retracement would play out so quickly but it has. The December futures contract reached $2.50ish before bouncing; although we think the $2.50 in the front month contract is probably a valid low, the recovery from here will be complicated by the “contango”.

Contango exists in all commodity markets with a normal price structure. It is the idea that the cash market price of a commodity will be cheaper than the first expiring futures contract, and the first expiring futures contract will be valued lower than the second expiring futures contract, and so forth. The difference between these two prices is the cost of carrying the commodity between now and the expiration date of the futures contract; these costs include storage and insurance of the commodity. To illustrate, the December natural gas futures contract is trading near $2.75, the January contract is trading near $2.95, and so on. Accordingly, while the December natural gas futures contract bounced off of $2.50 support as expected, the low in the January contract was near $2.72. We suspect that the process of bottoming in natural gas could mean the January futures contract will need to test $2.50 before the bulls are willing to step in. The December contract expires next week.

Our research shows that seasonal tendencies for natural gas remain weak to neutral through the end of the year. This is in contrast to the assumptions of many who believe natural gas prices should rise in the winter due to increased demand during the winter months. The reality is, much of the demand is accounted for in September and October, well before cold weather sets in. Also, many consumers use natural gas during the summer months to cool their homes and this keeps supply and demand fundamentals in gas more stable throughout than they were in the past.

It should be noted that our friends at MRCI have pointed out the fact that the January natural gas futures contract tends to lose value from November 24th through December 4th. This trade has worked 80% of the time in the last 15 years. This stat confirms our suspicion that the January futures contract will need to retest the $2.50 lows before a sustainable rally can occur. Thus, perhaps a better time frame for the bulls will be in mid-to-late December.

In addition to weak seasonals, we see the potential for some margin call fallout. Volatility in the futures and options markets across the board have triggered trading account margin calls. Margin call selling is blind in that it doesn’t pay attention to market fundamentals, the chart, or any other type of reasonable analysis. The only goal is to liquidate positions to preserve capital; logical behavior comes later.

Looking at the chart of January (not December) natural gas, we see support in the $2.75 area, but given the heavy seasonal tendencies, we expect the current bounce to be short-lived causing prices to slide toward $2.65 to $2.50. If you are a natural gas bull, these are the levels you will want to focus on as potential entry points. That said, oscillators on the daily chart are already oversold. Specifically, the Relative Strength Index (RSI) has dipped below 30 and the William’s %R is in the basement (below 10). Consequently, even if our analysis in regard to a test of the $2.50 in the January contract is accurate, big and volatile bounces will be part of the landscape. Look for resistance in the January futures contract near $3.02 and again at $3.15.