Monday, August 6, 2007

Income Trusts – Addendum to Natural Gas

This is a follow-up to the “Investing in Canadian Securities – Consider Natural Gas” post of about a week ago. First of all, let’s make one thing very clear. I am not suggesting you should buy anything. I am only proposing that, if the circumstances are good for you, there might be a place in your portfolio for natural gas stocks some day, and if that is the case, look at the income trust asset class as a means to get there.

As an addendum to that previous post, I wanted to show you the price relationship between oil and natural gas. The chart below shows the ratio of the price of oil to that of the price of natural gas over the past 10 years. Based on that history, we can calculate that the average ratio was 8.5 times (the green horizontal dashed line). We can also calculate the standard deviation of that relationship (a statistical number which measures the volatility around the average) and project two numbers which will help us better understand the history. These numbers are the blue line at a ratio of 10.8 and the black line at around a ratio of 6. The science of statistics now allows me to say that 2/3 of the time, the ratio was between 6 and 10.8. It also means that 1/3 of the time, it was outside of that volatility band. Now look at where the ratio is currently, 12.63 times. It is a law of nature that the relationship will eventually “revert back to the mean” and could even drop back below the black line as it did in 2001 2003 and 2006.

The probabilities for a return to the mean are quite high. It’s only a question of time. We just don’t know how we are going to get there. We can build different scenarios:

-1- The price of Oil drop precipitously and the price of Natural Gas is stable or up
-2- Or the price of Oil stabilizes and the price of Natural Gas rises.
-3- Or the price of Oil keeps rising but the price of Natural Gas rises even more.
-4- Or …
On the one hand, if you believe that generally oil service stocks in the US lead the price of oil, then the following chart suggests that oil may go down.

One the other hand, the US Oil fund is at a critical stage, smack on its long term downtrend line (S-18). Will we have a breakout or will that be too much resistance (remember, the pro usually start selling short right at the downtrend line)?

Nothing changed with Natural Gas prices this week, so there is not need to update the charts.

However, if we look at a monthly chart of Natural Gas and Oil, as many fundamental analyst might postulate, it is in our rights to assume that the price of a commodity follows its long term growth rate in consumption, subject to some cyclicality due to seasons, weather, brightness of the moon (?!) and so on.

If we draw a long term trend line as shown below, and then a parallel line above which contains most of the price action (the art part of technical analysis), besides finding patterns, we can evaluate the position of the current price with respect to the long term growth rate.
I will let you draw your own conclusions.

Natural Gas


Finally, I have drawn the Fibonacci retracement lines if only to confirm a point. The standard interpretation of these lines goes like this follows.

When prices correct, they usually move down to the minimum 38% line. Most of the time however, price move down by about 50% of the previous up move (the $51.03 December 07 was slightly above the $48.49 projection for Oil). Finally, the 62% price line is generally considered as the “make or break” line. It is the ultimate support line. If that breaks, then it is expected the stock/commodity will continue downwards towards the initial price ($17.12) or a 100% correction which then puts in jeopardy the trend because the previous low may be violated.

The lines are a nice tool to use. However it must be used with a grain of salt. For example, does anyone believe Natural Gas could go back to the summer 2001 low of $1.88? I just don’t think so. But there again, I did not use the Fibonacci retracement lines as prescribed by pure technical analysis doctrine. I cheated a little bit. Do you know why?

The Word

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