Natural Gas and Contrarian investing

Remember when I bought natural gas a couple weeks ago--mainly because NO ONE liked that sector, even the CEO's of natural gas companies, who should be the industry's biggest cheerleaders?

Well, guess what--natural gas company shares have exploded, up over 30% in certain cases. My mutual fund purchase is up 25%, and ATN has more than doubled, a triple-digit bagger.

Logic? The world is awash with natural gas supply, due to demand destruction from a worldwide economic downturn. Natural gas prices surely must decline further, right?

Well, the reason that conventional logic doesn't work as an investment thesis is because markets are not always rational, and when they are rational, they tend to become over-extended and distorted.

But let's examine this scenario further before we declare the madness of markets. If the cost of producing natural gas is $4.00 per British thermal unit, and the market price is $3.50, companies will eventually shut down natural gas wells, in order to suspend losses with each delivery. They have done exactly that, as there are now 45% fewer wells. Shutting them down is easier than starting then up again. More on that later.

With capacity reduced, prices eventually will stabilize and rise, as demand recovers and absorbs excess inventory. As prices rise above production cost, natural gas companies will look to dig new wells to increase their profit margins. However, that's not so easy. Starting up a well takes a lot longer than shutting one down--hence a time lag before bringing capacity on-line. With supply no longer able to keep up with increasing demand, prices rise further. That's the typical supply/demand cycle, and astute, but courageous investors need to account for. Perhaps I'm not so crazy after all. The economic laws of supply and demand do work, but not always in the timeframe most investors anticipate.

As a contrarian, you want a consensus to develop--because it's usually a confirmation that the consensus is wrong when it comes to pricing reversals. It's cyclical. The rule of thumb is when there is a 60/40 ratio, follow the trend--the "trend is your friend" is an appropriate slogan. But when the consensus is overwhelming--perhaps 90/10, you better look for the exits, as the overwhelming majority is almost always wrong.

With natural gas, the selling pressure has been so intense since mid-2008, that the number of sellers has been exhausted--the market ran out of sellers. Prices had to bottom. I follow several indicators to monitor investor sentiment, but it's easier said than done. When your social instincts are to chase the latest fad, it's difficult to go against that same crowd, especially when they are well-regarded. But when it comes to predicting inflection points, it's a prerequisite for investing success.