A rare buy signal in natural gas

Key points:

• The 1-year futures spread as a % of the 1st contract price for natural gas plunged below -60% and reversed
• After similar spread reversals, natural gas rallied every time from one week to twelve months later 
• Natural gas stocks typically follow the commodity higher, with solid returns across most time frames

A mean reversion opportunity after a significant decline

Warm weather around the globe and especially in Europe, sent natural gas prices plunging at a historic rate. Over the last six months, the commodity declined by -77%, shattering the previous record decline of -68% from 2001. 

I track dislocations in the natural gas market by monitoring the 1-year futures spread as a percent of the 1st contract price. Last week, the spread fell below -60% for only the 6th time in history.

While extremely rare, annualized returns are uber bullish when the indicator falls below -60%. Conversely, natural gas is highly likely to decline when it exceeds +40%, which it did in 2022.

As stated in previous research notes, I dislike catching a falling knife. I would rather wait for a reversal signal, even if it means I miss some of the early stages of the recovery. 

With that in mind, I created a simple trading signal for the futures spread. After the indicator declines below -60%, the model looks for a 3-day net change increase in the spread of +19%.

 On Monday, the 3-day net change surged by the most significant amount in history, triggering a new buy signal.

Similar spread reversals preceded bullish natural gas prices

When the 1-year futures spread as a % of the 1st contract price falls below -60% and subsequently increases by 19% over three sessions, natural gas had a 100% win rate across every time frame. 

If you were wondering, the signals in 2006 and 2020 were triggered almost immediately after the spread fell below -60%, which is the case now.

With the 3-day net change increasing by the most significant amount in history, let's look at a short-term outlook table to see if we should expect some giveback in the next few days.   

A pullback in the next few days would not be unprecedented, which is what I see on my screen today.  

An additional way to position for a rally in natural gas futures

My colleague, Jay Kaeppel, published a note on natural gas seasonality on Monday. The cliff note version says seasonality is about to turn positive. Jay suggested one option for playing a rally in the commodity would be to allocate capital to the ETF (UNG). 

Another option would be natural gas stocks. As always, this is not a recommendation for any particular stock. The intent is to show an example of a potential outcome.

Natural gas stocks should trade higher as long as the commodity rhymes with history.

What the research tells us...

Natural gas prices plunged by the most significant amount in history over the last six months. In doing so, the 1-year futures spread as a percent of the 1st contract price declined by more than -60% and subsequently reversed higher, triggering a buy signal for natural gas. After similar spread signals, the commodity was higher every single time from one week to twelve months later. One possible way to play a rally in natural gas would be to allocate to stocks with a high correlation to the commodity.