A natural gas rebound?

October 22, 2015 01:00 PM

Natural gas prices have been in free fall since reaching a four-year high of $6.15 in February 2014. Prices possibly bottomed this past April at $2.49, but as of early September we were still around $2.70 with no momentum toward a recovery in site.

What gives?

We’re near record levels of natural gas supplies and U.S. production in 2015 is higher than ever despite lower prices. The EIA forecasts a 5.4% increase in 2015 versus 2014. In addition, continued exploration finds like the recent discovery by Eni of the “supergiant” gas field in the Mediterranean are encouraging to the long-term supply picture.

At times like these, historical precedent can be a powerful ally, but many traders don’t have the right tools to analyze this effectively. Too often they rely on past similar percentage drops. Why is this approach flawed? 

The two charts below show a price increase during three months, but if you were an investor in both you probably would be considering selling scenario 1 and holding on to scenario 5. This is a simple example, but illustrates why the way a commodity is being traded affects the future actions of market participants.

So, how do we find analogs from history that more effectively capture the trajectory of the current trading pattern? EidoSearch takes a sample numerical pattern, and searches through historical data to find mathematically similar instances on a scale of about 100 billion patterns per minute. 

For natural gas, we took the current one-year price trend and found eight statistically similar matches looking at 30 years of history. The most similar match is from September 2005 to 2006. “History repeats,” shows the current one-year price trend (blue) and the one-year price trend from ’05-’06 (black). 

Natural gas was coming off all-time highs in 2005, and a number of factors led to less demand in 2006, including lower heating demand in Q1 and Q4, an increase in on-shore production, above average storage supplies and recovery from the devastating 2005 hurricanes (Katrina and Rita). There are certainly some similarities to today with current on-shore production capacity and inventories.

The eight similar occurrences show the average return in the next year is 52.7% and seven of the eight historical instances are up at least 27.4%.

There is no historical precedent for a continued drop in natural gas prices in the coming year. Having this type of objective barometer can be a powerful ally for the investor.

About the Author

Steven Zhang is the CEO at EidoSearch.com, a Ph.D. in electronic engineering and an internationally renowned expert in information processing technologies. His expertise is in the areas of signal processing, multimedia content analysis, computational intelligence, pattern classification, as well as applications in bioinformatics and finance. @EidoSearch