Tuesday, July 31, 2007

Investing in Canadian Securities – Consider Natural Gas

I believe that market conditions dictate the longer term strategy one must orchestrate independent of opportunistic (perhaps momentum driven) daily trades that we must execute in order to make a living every day. This bull market has been alive for a more than 4 years now, so that there will be a time it moves into a decelerating phase Three to six months later, it will be confirmed by an economy that is “contracting”. We may be in that higher risk zone right now. But market timing is beyond the scope of this article. Besides, the “market timing” community is so full of “experts” that I prefer to avoid that crowd and focus on something else.

Investing in Canada means that you are investing in natural resources. Natural Gas is such a resource which is very different from most others because its price is not determined by World consumption but by North American supply and demand. Fundamentals may not be favorable to higher prices in the very near future (the storage count is up, where are the hurricanes and major heat waves this year?), but technicals do lead you to think outside that box. When I reviewed commodities this week-end, I came across this old friend who had a story to tell me.

Dark Green line = Long Term Bullish Up trend line sloping upwards at a 45 degree angle
Light Green line = Short Term Bullish Up trend line sloping upwards at a 45 degree angle
Red line = Bearish Long Term Down trend line sloping downward
Light green horizontal line = Support line
Blue horizontal line = Resistance line

The price of gas is trading around $6.00 right now and that is a very important price for a Point and Figure (P&F) analyst. It establishes a double bottom, but wait a minute, perhaps it’s the right shoulder of a Head and Shoulder (H&S) pattern with a neckline of $8.00! The three green arrows depict de S/H/S formation. If this is true, then the price must not trade at $5.50 or below because that would be a breakdown which would negate this H&S formation. However, we know that two specific events could happen. The first one is that if the price trades at $7.50, we will have a “Reversal into a column of X”, a suitable entry point for an investor. Next, if the price hits $8.50, we then have a H&S neckline breakout and P&F measuring techniques would provide for a minimum target price objective of $12.50 (Orange lines). As of today, that looks like a nice “Value” proposition.

Now that I have identified a longer term potential investment, the next step is to look at a traditional chart. Below we have a weekly chart. You should not be surprised that it also shows the H&S formation. But for me, it is clearer on the P&F chart. Using traditional price objective techniques, a breakout would project a price of $12.52, the same as the P&F projection.

The second most important factor that I use in my investment process is relative strength. Typically, I will own a security only if its performance is better than that of the TSE Composite Index. I may write about that in a forthcoming article. In this chart, I use relative strength (see low panel of the chart) to be aware of the critical natural gas to oil price relationship. As shown on the chart:

-1- Natural gas has been underperforming Oil since December 2005 and,

-2- The relationship is currently at a three year low!

We are smack in the middle of earnings season, so we must address the “fundamental risk”. There are two that we must be aware of.

-1- The first is earnings surprise risk for gas companies. The best way to evaluate that, is to use a 12 weeks moving average of price in order to figure out the average price companies received during the past quarter. The blue vertical lines correspond to the end of the quarter for most companies. The intersection between the vertical lines and the blue moving average (blue arrows) is a good guesstimate of the price companies received during the quarter. It appears to me that the average price was higher this quarter compared to the 1st quarter. If the cost structure has not increased, other things being equal, earnings should at a minimum be equal to last quarter or slightly better. In fact, natural gas prices increased 16% while oil prices decreased 9% during this 2nd quarter.

-2- But we all know that the market is looking at future earnings. It is clear that the average price this quarter is lower than the second quarter and that is what the market is focusing on right now. The right shoulder needs an urgent upswing from now to September 30 in order to reverse the average price received by companies. If that happens, on volume, hang on to your hats because both fundamental and technical analysts will identify the opportunity at the same time!

Earlier I mentioned that the investor’s entry price might be at $7.50. If you are more short term oriented, then you should use other “techniques” to figure out your entry price. The legitimate question might be: How do you participate in such a potential recovery? That should be the subject of a forthcoming post. Let me give you a hint: Income trusts anyone?

The Word


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