Why natural gas looks cheap here.

February 12, 2007


We’re Not Running Out of Gas, So Why Be Bullish?

Ever since the December 27th low of $5.740, the market has had a nice run-up to highs last week of $8.035 with some of the best pure weather related volatility seen in quite awhile and after today’s sell-off, the question that lingers is where to next?

In the bears argument is the fact that we have such a large amount of gas still in storage and will not get to an uncomfortable level this winter. I did see one analyst throw out some numbers in his weekly report on how we might end up the season matching withdrawals of last years remaining period (ending 1.787 TCF on a –70 average of last 8 weeks), and also matching the five year average (ending at 1.619 on a –91 average of last 8 weeks). I will concede that if we did indeed finish at a level of 1.619 or higher, it would look a little bearish.

Now from a bulls perspective, this market has had a nice move to the upside but failed to close over the 7.93 area that would have attracted sizeable short covering into the market, I say this in light of seeing the COT’s depicting an epic battle with the net non-commercial position changing very little from an even divide telling me that the big bears rode this large move higher without closing out. How close were we to seeing a sizeable short squeeze? Now that we have sold off to the current 7.20’s on a warming trend, I would like to point out a few things. First, to use the storage math above at this point in the game depicts more “talking the book” than reality. The reality is that we have a fairly good idea that Thursday’s withdrawal will be around –250, taking us down to 2.097 TCF. Next weeks withdrawal is estimated to be roughly –218, which would take us to 1.897 TCF. Now let’s estimate the last six weeks using the above favored method of matching last years average withdrawal of –75. That would leave us with 1.429 TCF, a far cry from 1.787 TCF. If we matched the five-year average for the remaining six weeks of –82, we would be at 1.387 TCF or 232 below the bear’s estimate, and –308 from last years finish.

Let’s do some projections on where we finish injection season now. Last year we injected 1.766 TCF over 29 weeks. We had no supply disruptions and for the first time, had two mid-summer withdrawals on peaking loads due to the ever-increasing power demands. Projecting a carryout of 1.429 and just matching last years rate would take us to 3.195 or –88 below the five-year average. If we were to carryout 1.387, that would put us at 3.153 or –130 below the five year average and –308 below last years level of 3.461 TCF. Is this in the “comfort zone”? I think not as the “comfort zone” needs to be adjusted for the sizeable build out of the demand base of the last few years. So the old 3.1 TCF to 3.3 TCF target area should now be 3.3 TCF to 3.5 TCF. As a reminder of how fast we can draw on stocks, let’s go back to the recent winter of 2002-2003. We started that winter with a “comfortable” 3.172 and ended with only 642 BCF remaining.

With the El Nino signal now neutral, it is likely that we will not have the conditions this summer that impeded the Atlantic basin last year. Also with power demand increasing near 3% year over year, I would suspect that we have a hard time reaching traditional comfort levels.

The forward curve at this point is looking relatively undervalued with such a fast switch of underlying fundamentals witnessed over the last several weeks, and the front of the curve will follow. Longer range forecast has a return of some arctic sourced air into the lower 48 at the end of February, and into the first half of March thus making it likely that we will exceed last years remaining withdrawal rate and create a larger hole to fill than what was depicted. Furthermore, March has yet to price withdrawals out of the ground as it trades in discount to April creating the potential for a volatile finish to the 2007 March/April spread that has caused so much pain. I fully expect another assault on new highs before this month is over as it is now about forward valuation. If you’re looking to lock into protection, I would start to scale in at these levels.


-Comanche

 

Per our discussion, I got to thinking more about what explains volatility in natural gas... and perhaps the center of it is an inability to practically arbitrage spot gas to forward gas.

It seems to me spot gas, having its own issues of pipe demand, imbalances, flow limitations, storage issues and costs ... is really not the same animal as future gas - this is why value and price is so hard to peg down.

For example, spot henry is in the 7.60-7.80 range right now. March henry is 7.15. Considering only three weeks seperate the two, you would think an opportunity would exist to sell spot and buy futures until they converge. But pipe flow limitations, inability to store, etc. and who knows what else (you can suggest) make it impossible. Furthermore, I assume there is only so much demand for day ahead gas (which dictates price as well), dictated precisely by how much is used ... Any idea how much day ahead gas is sent back into storage fields? Is that practical for the cash buyer?

Just trying to make sense of the curve ... doesn't seem to make any sense summer gas (apr+) is more expensive than winter gas, even if forecasts are questionably bearish right now, especially considering your points about storage.

The point remains the same that a summer drawdown, a hurricane or three, and a cold winter could all pose a threat to draw inventories down to 0 or near next winter. That doesn't factor in potential nuke maintenance, trending NG demand upsurgence from canada oil sands production, lower canadian NG production via lesser incentives by poor govt policies, and flat y/y US gas production, in the face of as you say +2-3% y/y power demand.

The market finally has support at least, since we've burned off these inventories. Feels safer to buy than short right now. Winter could end tommorow and we'd be easily down to 1700-1800bcf and the picture is still bullish enough.

 

Anticipation of higher electricity demand in the summer for the forward looking utilities perhaps? They might be overly cautious as energy prices went limit up for a number of days on the west coast last summer.

Spot and Day ahead gas is so "out of whack" because of the electricity industry

 

Despite the fact that I don't agree with your outlook, Comanche, you do make some interesting and valid points. True, power demand is helping to fuel demand for natural, and that decreased imports from Canada and flat domestic production are both weighing on the market...BUT, we have record amounts of natural gas in storage, hurricane damage from the summer of '05 is coming back on line, rig counts are up, and LNG is starting to gain ground (and sites for terminals) and is expected to be imported in greater and greater quantities going forward.

As far as storage goes, I will not prognosticate as to what level of gas we will have in the ground going into the injection season, but suffice it to say it will be well above the five year average, and let's not forget that the very five year average itself is of questionable validity as that figure includes the anomaly of last year's record storage glut. I have already heard reports that last year's El Nino pattern served top diminish wind shear and may have been responsible for hurricanes failing to make it into the Gulf, and that this shouldn't be the case this year, but I think that aside from the risks of weather related catastrophes, we are in good shape from a fundamental perspective.

Fundamentals do not always dictate price movement, and I realize that technicians can come in and push the market whichever way they see fit, but based on fundamentals alone I would anticipate this market to correct to the downside in the short term.

 

fundamentally we're in a commodities bull market. we're going to end the storage season in 1300-1400 range, which as you say is on the higher end of the 5 yr average, but not as bad as last yr. Furthermore, while production is sufficient now, the cost to produce a new MCF is significantly higher than 5 yrs ago ... that will affect the supply side significantly if there is any weakness in prices. That argument is more applicable to long term price implications though.

As long as the cost of oil is $50+, and drilling expenses remain high, there's no reason for gas to be significantly weaker besides 2000bcf in storage at end of season.

Right now I would think the (downside price possibility of) relatively mild weather is almost entirely priced into the market, plus or minus 30 cents.

realistically we don't even need hurricanes keep prices elevated in the market. power demand is a very different animal now, and I'm sure summer net withdrawals won't be a one time occurrence from last season. Not until you start seeing a massive amount of LNG terminals on the coasts and locations not afflictable by hurricane risk, and nuclear power capacity increasing will you see hurricane premium and general price and volatility coming down on NG. Reasonable impact on the NG market from LNG and Nuclear capacity are 10-15 yrs off at best.

PS: LNG won't necessarily be cheap. But I agree it'll serve as a price volatility reducing mechanism.