More upside in oil? NatGas climbing a “wall of worry”

As oil prices top $125 and take other energy prices higher, where do oil prices go from here?

Crude oil appears to be overbought in the short term but sentiment doesn’t seem to be at a bullish extreme indicating that there may be more upside in black gold. However, oil does seem to be extended relative to other commodities.


Fast money is in a natural gas crowded short
A look at the CFTC commitment of traders data shows two different faces of sentiment in the energy complex. While natural gas prices are nowhere near their all-time highs, large speculators (read: hedge funds) are showing record levels of skepticism in natural gas and they are net short the commodity. Readings are not only at a crowded short level but their bearish positions are off the charts.Hedge funds long crude but not excessively bullishness yet
By contrast, large speculators are net long crude oil but readings are not at an extreme level despite the record oil prices. This data from the CFTC, combined with public sentiment readings, suggests that in the absence of excessive bullishness in crude oil, the commodity does have room to move a bit higher given its positive price momentum.Buying natural gas seems less risky than buying oil right now
The contrast in sentiment readings suggests that natural gas prices have more upside potential than oil prices and could hold up better should the energy complex correct. The chart below shows the price ratio of natural gas to crude oil, along with its long-term average and the one standard deviation bands around the average. I highlighted the price divergence between these two commodities in December and again in February. The natgas/oil ratio bottomed out in late December and has since turned up but likely has more to go.A long natural gas/short crude oil position would have a potential upside of 15% today, based on the conservative target of reaching the lower one standard deviation band. If we assumed that the ratio moved up to its long term average, the position would have a profit potential of 50%.


Oil looks extended against gold too
Another way to look at oil is to look at its performance against gold. The chart below shows the price ratio of gold to oil since 2000. Gold prices topped out against oil prices in late December 2007 and the ratio reversed itself dramatically. Oil now appears quite extended relative to gold, as it does against natural gas.The commitment of traders report on gold (not shown) shows that sentiment readings are relatively neutral. As a result, I would prefer a long natural gas/short oil trade rather than a long gold/short oil trade.

Still more upside potential in the NatGas vs. Oil trade

Back in early December I posted about the oil and natural gas divergence in price and sentiment. Natural gas initially declined against crude oil after that post but has since risen about 10% on a relative basis.

A update of the Commitment of Traders data from the CFTC shows the relative bull case for natural gas vs. crude oil remains intact. The "fast money" large speculators continue to be have a crowded short in natural gas and giving a contrarian bullish signal. On the other hand, the signal from the COT data for crude oil is still neutral.

An interesting Oil and NatGas divergence

Natural gas hasn’t followed the rally of crude oil. Even as crude oil approached $100 natural gas languished in the $7-8 range, compared to the highs of $14-16 seen in late 2005. The accompanying change shows the ratio of the price of natural gas to crude oil futures. I have used the 12-month strip as the reference prices (1/12th the front month + 1/12th the 2nd month + … + 1/12th the 12 month future) as natural gas prices can be seasonal. The chart shows that natural gas prices are probing new lows against oil prices.

A look at the Commitment of Traders data from the CFTC shows a very different kind of story. Commercial traders, who are usually thought of as the “smart money”, are excessively long natural gas and giving a bullish signal. On the other hand, the signal from the COT data for crude oil can be best described as neutral.

As a former trader I can attest that all these fundamental and sentiment signals don’t matter until they matter. Others have traded successfully on COT data but I have found them problematical as a timing tool. These conditions have persisted for several weeks. Just because these conditions are at extremes doesn’t mean that they can’t get stretched further.

In future posts I will examine other interesting divergences in the energy and energy related markets.