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As the market is finally discovering that the entire greenshoots - economic recovery story was nothing more than a false spring, some interesting discrepancies between price and risk are starting to develop in commodities land.

Yes, the great “long commodities & short the dollar” paired trade has unwound.

But, one commodity stands out as perhaps being too oversold, both technically and fundamentally. And that’s Natural Gas.

The UNG natural gas ETF is now at an all time low since it’s inception vs. the USO oil ETF, vs. the XNG E&P stock index, vs. the CRB commodity index, and vs. gold. And perhaps most importantly, it is now below the cost of production for most natural gas producers.

Yes, natural gas supplies are high, but the rig count has collapsed. Reuters reported last week that the number of rigs drilling in the U.S. for natural gas has now dropped to 688, down 55% from the same week last year when there were 1,539 rigs drilling for natural gas.

Natural gas whether viewed as an energy trade, as a commodity, or as an inflation play, is now compellingly cheap. And given the collapsing rig count, I believe it’s setting up for a when, not if - price spike.

Here’s a couple of interesting charts from Chesapeake Energy that support that “when, not if” price spike thesis…[click on the charts to enlarge].

Natural Gas Rig Count Vs. Supply

Natural Gas Production Cost Vs. Price & The Price Spike Cycle

So what’s the trade?

Do you just buy the UNG ETF? Maybe start with a 1/3rd, or 1/2 initial entry position given the still weakening economy, soft demand, and a DOW that may be in correction mode during earnings season?

Or, how about a long/short paired trade that hedges you to any major correction in the broad market, or in energy demand? You could go long natural gas/short oil via UNG/USO, or a long the UNG and short the XNG E&P index, or short the various energy sector ETF’s such as the XLE.

The trade I actually like the best from a risk:reward perspective, is to “sell”
2011 LEAP Puts on the UNG ETF. With LEAPS you get “time” to be right, and the premiums are very attractive.

The $10 to $15 strikes in the UNG all look interesting, and are offering premiums from $1.95 for the $10 strike, to $4.90 for the $15 strike.

I’ve begun to sell puts across that range, in addition to taking an initial long position today in the UNG, with stops set to Natural Gas holding a double bottom re-test at $3.25ish.

The $64 question for natural gas here, is whether the selling has already been done in anticipation of weak earnings, and an economy that still hasn’t gained traction into recovery. Technically, the correction in UNG seems to be saying just that, as it, and the commodity trade broke down before the DOW.

So what’s the catalyst?

I think there are three. First, it’s only a matter of time before the collapsing rig count re-balances supply to demand. Excess supply, with market prices below the cost of production is unsustainable.

Secondly, I believe there will be a 2nd stimulus package announced this fall if Q3 earnings are weak (and I think they will be). And Laura Tyson of the Obama administration is floating that trial balloon as I type.

Thirdly, there is the inflation trade. Where natural gas and commodities will trade as a finite resource vs. infinite fiat flowing from the printing presses of global central banks.

And there is also the Iran geopolitical wild card. An event catalyst that looms even larger, given the apparent green light given to Israel to attack Iran, by Vice President Joe Biden this week.

While no trade is free from risk, and while we may be early in trying to find a bottom in natural gas, a very attractive discrepancy between price and risk is starting to form.

SliderOnTheBlack