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November 17, 2009

Gold to Natural Gas Ratio and What It Could Potentially Mean
by Sol Palha

"Every success is built on the ability to do better than good enough." - Anonymous

Right now we have an extreme development in the natural gas market; natural gas prices have dropped to a multi year low and the oil to natural gas ratio and Gold to natural gas ratio are both trading in the extreme ranges. History illustrates that all extreme moves nearly always produce counter moves in the opposite direction which are just as strong if not stronger. In Feb 2009 we made the following statement to our subscribers in regard to the oil to Gold ratio.

In May of 2008 we stated that the Oil to gold ratio favoured gold over oil and that it would make more sense to invest in Gold or Silver bullion. This proved to be true as oil prices plunged and Gold rallied from 720 to the 900 ranges.

Normally one ounce of Gold should buy roughly 10-12 barrels of oil, but it can now purchase between 22-24 barrels of oil double what it could just a few short months ago. This 3 year chart very clearly illustrates how extreme the current move up is and all extreme moves always result in producing equally strong moves in the opposite direction. This chart clearly indicates that it now makes more sense to jump into oil and oil related stocks than jumping into Gold stocks. Market update Feb 03, 2009.

Currently the ratio is in the 14 ranges after having dropped below 13 in August of 2009, clearly illustrating that oil was a better investment; from its low to its recent highs Oil has rallied well over 120%. However, our focus now is not on oil but on natural gas.

Right now we have an extreme development in the Natural gas sector and the following graphs clearly illustrate this development. The Oil to the natural gas ratio is now currently at 26 after spiking as high as 29.

The gold to the natural gas ratio is also at an extreme inflection point; we also have multiple trend lines in place here. For the past 3 years, the ratio has traded between the 220-260 ranges so this massive spike up to 400 is definitely a move into the extreme. Market update Sept 8, 2009.

Since making the above statements in Sept, the ratio has pulled back considerably and natural gas mounted a very strong rally that produced a short term gain of over 100%. If you look at the chart closely it clearly illustrates that the ratio could drop a lot more before arriving at levels that are characteristic of historic norms. Given that the move up was so strong, we would not be surprised to see the ratio drop to the 100-120 ranges. We would like to add one very important note here. We are in no way stating that Gold is not a good investment, what we are simply stating is that right now Natural gas could make for a better investment for those seeking a higher rate of return. In May 2008, we stated Gold made for a far better investment than oil when everyone was busy proclaiming oil was going to surge to the 160-200 ranges. We are in the midst of a commodity boom and thus at certain points in time certain commodities will provide a better rate of return than others and that's the point we are trying to make.

The chart below very nicely illustrates our point that extreme moves in one direction nearly always produce counter moves in the opposite direction.

When the oil to natural gas ratio hit an extreme in Jan 2009 when it put in a new 3 year low, the corresponding move up was even stronger. From a low of roughly 6, it rallied all the way to 26 for a gain of approximately 333% in a period of 8 months. In August this ratio once again entered the extreme ranges and this was immediately followed with a sharp move in the opposite direction. Even though the ratio has pulled back from its peak in August, the ratio still has some way to go to before it starts trading in the normal ranges, which roughly fall in the 8-10 ranges.

This very long term chart of natural gas very clearly illustrates how undervalued natural gas currently is; if we adjust these prices for inflation, natural gas is almost being given away for free. From a long term perspective such extreme developments never last and there is always a turn around. Individuals simply want things to turn around over night and thus in most cases miss the opportunity because they cannot take the pain that goes with waiting. Patience always rewards handsomely, while haste always leads to waste.

Natural gas mounted a very strong short term move up, and so it would be normal for it consolidate and trade sideways before building up energy for the upward phase. From a long term perspective natural gas might have finally put in a multi decade bottom. Its one of the few hard assets that has virtually done nothing in the past 10 years and as such this is a very huge anomaly given that the dollar has shed almost 40% from its 2001 highs.

Some compelling reasons to be bullish on this sector

Almost everyone jumped into this trade for it appeared to provide a perfect shorting opportunity. However, as we have already mentioned natural gas prices have spiked almost 100% from their lows and individuals should also remember that no trend lasts forever. This clearly indicates that while this strategy might have been a good way to make some easy money, the trend has changed and the odds favour higher prices in contrast to lower prices.

One must remember that the markets are forward looking beasts and after taking such a beating for such a long time all the bad news is already priced into this market. Thus going forward a small uptick in positive news could have a profound effect.

The big news was excess capacity, that is what prompted traders to jump in and short the hell out of this market. The good news is that natural gas supplies are close to hitting maximum storage capacity. The EIA recently announced that natural gas supplies hit a record 3.7 trillion cubic feet and there is not too much more room before maximum storage capacity is hit.

If winter turns out to be a little colder than expected, then we could draw down on those supplies a lot faster than expected. This is an example of the small uptick in positive news we mentioned earlier that could have a big effect on this market, especially after the massive volume of bad news it has had to deal with for over 1 year.

There are only so many individuals that can short a market before you reach some sort of inflection point. We believe that those that joined the party late were forced to close their positions out and hence the rapid move in price from 2.70 to the 6 dollar ranges. Now, the late comers are probably closing out their shorts instead of opening new ones.

It soared to new highs in 2008 and then embarked on a very sharp correction that ended with it trading to multi year lows; to be precise a 7.5 year low. It has moved from one from extreme to another, and just as it topped suddenly, it bottomed just as suddenly. It rallied 100% from its lows before pulling back, and we think it has a long way to go before another long term top takes shape.

The fundamentals and technical Analysis both clearly illustrate that Natural gas could make for a good long term play. We have spoken of extreme developments in the past and in 9 out of 10 cases these extreme moves always produced counter moves that were just as strong if not stronger. We have a massive long term anomaly here, natural gas prices dropped to extreme levels and when inflation is taken into consideration, one could go as far as stating that natural gas might have actually put in a multi decade low.

"Be awfully nice to them going up, because you're gonna meet them all coming down." - Jimmy Durante 1893-1980, American Comedian

Sol Palha
TacticalInvestor.com

Sol Palha is a market analyst and educator who uses Mass Psychology, Technical Analysis and Esoteric Cycles to keep you on the right side of the market. He and his partners are on the web at www.tacticalinvestor.com.

The information contained herein is deemed reliable but no guarantee is made about its completeness or accuracy. The reader accepts this information on the condition that errors or omissions shall not be made the basis for any claim, demand or cause for action. Any statements non-factual in nature constitute only current opinions, which are subject to change. The author/publisher may or may not have a position in the securities and/or options relating thereto, & may make purchases and/or sales of these securities relating thereto from time to time in the open market or otherwise. Neither the information, nor opinions expressed, shall be construed as a solicitation to buy or sell any stock, futures or options contract mentioned herein. The author/publisher of this letter is not a qualified financial advisor & is not acting as such in this publication. Investors are urged to obtain the advice of a qualified financial & investment advisor before entering any financial transaction.

Copyright © 2004-2010 Sol Palha, All rights reserved.

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