Will Natural Gas Be the Next to Rally?

It’s hard to get overly excited about natural gas when inventories are 22% above their five-year average and 31% above last year’s levels, and the gap between current inventories and historical averages has been rising steadily throughout the year. However, while the fundamentals aren’t necessarily attractive, the historical relationship between the price of natural gas and oil is nearing record extremes.

With oil nearing 70 and natural gas below 4, the current ratio between the two commodities is now over 18. Following prior periods when the ratio went above 18, while natural gas hasn’t always rallied, it has always outperformed oil. Additionally, as we near the end of the second quarter, natural gas is entering what has historically been its best quarter of the year. As shown in the chart below (click to enlarge), the commodity's average return (using the front month futures contract) during the third quarter of the year has been 12.95% with positive returns 63% of the time.

Comments

[Stone Fox C...:]

everybody knows this yet it hasn't changed the price action. hmm...

Jun 08 01:07 PM

[zeppo:]

One thing that seems certain from the chart is that, on average, the price of natural gas goes up every quarter. So do potato chips.

Jun 08 01:19 PM

[tuj:]

"However, while the fundamentals aren’t necessarily attractive, the historical relationship between the price of natural gas and oil is nearing record extremes."

Shale production throws this argument to the ground. There was no shale production before; there is now. Therefore your historical relationship is of dubious use.

Jun 08 01:27 PM

[Thomas Clou...:]

Good information. This is quite a delima. I went ahead and am long natural gas as of last week mainly for technical reasons. However, I am usually a fundamental investor. You would think at the current price some Natural Gas drilling companies would be forced to close their doors and therefore swing Natual Gas back up. Also the governments around the world are printing money and the next time the stock markets drop 20+% the money creation will again be astonshing on a global basis.

Jun 08 01:34 PM

[basehitz:]

This market seems more to respond to trader speculation than fundamentals. We all know the FAs, high storage, low drill rig usage, shale potential, etc.

Now we need something that makes it move. . . traders. I mean, just look at the crap with oil last week. High stoage, falling usage, yet Government Sachs reportedly has a big bet on. So as the rally tires, they upgrade their target from $65 to $85. And what was the fundamental basis? They say it was the USD falling, yet the move was disproportinate between the two.

Back to NG. It is hurricane season. We don't even need a storm to hit anything. We only need to give the traders an excuse to rip it. And after Da Boyz have reaped their gains, then they will send out all their talking heads with higher price targets to persuade the sheeple to take what will then be their overpriced shares.

So, how to trade? Thursday, during the weekly bungie jump, I bought a bunch. This week, more cheap shares should be available either from market selloff, oil selloff, or just make up whatever you want. Eventually, a hurricane will be in the discussion and the traders will do what they do.

The primary fundamental I am watching now are the US dollar and implications for inflation. Given how cheap it is, this would seem like one of the safer places to hide. In general, I like commodities now. DBA I like as well.

Jun 08 01:47 PM

[Mmarrkk:]

Why is LNG favored? Because people invested billions and billions into the facilities and now will run them at their ultra low operating cost structure and ship the gas. Once you've made a $5 billion investment, you have to get revenue, even if you make a very small profit margin.

Shale gas production increasing like a flying banshee...whatever that means. But yes, gas production from the shales continues to skyrocket, even though storage is very high and prices are at or below the increment cost to drill, complete and operate the new shale wells. Part of that has to do with the expiration of leases...you have 3 years to drill and if you don't you lose the lease and have to re-lease at higher costs. So folks are drilling lots of wells to "hold the leases" with production. Production holds the lease for as long as the production continues.

Jun 08 01:51 PM

[Buck East:]

If you are long gas now you are ignoring the fundamentals. Demand is way down and will continue to be as the U.S. economy is a sick, fetid corpse. Unemployment continues to grow. Meanwhile, shale and lng means that supply will continue to increase, and shale well won't be shut in because most operators are hedged into 2010 at profitable levels, and because they CAN'T BE SHUT-IN--the fractures collapse and production levels never recover even after a re-frac'ing.

If you are long UNG you are waiting for the greater fool.

Jun 08 02:07 PM

[tuj:]

"Is shale production increasing or are less businesses around using any kind of energy? "

Both.

"Are any new power plants scheduled to come on line in the Next 12 months? If there are, what will they be using?"

Yes, and most are gas-fired combined cycles.

"9-12 months from now, there will be a big surge in energy demand. That's not really very far away."

No. Energy demand growth is very steady and has actually moderated previous to the economic downturn. See EIA data. The energy demands are not an issue; its an issue of fuel input cost. Nat. gas and coal are the competitive fuels for power demand; with normally NG setting the margin.

"Shale gas production costs vs price of Nat. Gas?"

Depends on the producer and who you ask. And the competitive cost of coal matters also (nymex spec, not PRB), and the demand for met. coal from the steel market (which is weak right now). And you have to consider that several producers sold their forward production last year at very good prices.

"I certainly don't have a clue but I do know that LNG is favored for no reason I can Fathom."

LNG is how you get gas to places without enough production, or without enough storage. The US is the last place where LNG ends up at; meaning if no one else will take it, it gets dumped on our market. There are about 7 diversion points before the commitment has to be made to take the cargo to the US.

Jun 08 02:09 PM

[tuj:]

Buck East is also right about the shale geology: you cannot shut in the wells for an indefinite period of time like conventional plays without having to re-frac the well.

Jun 08 02:10 PM

[Buck East:]

Mark--I generally agree with you, but don't make too much of producing in order to hold leases. Re: holding by production--most Haynesville and Barnett leases are 3 year primary terms, while in the Marcellus your're looking at 5 to 10 years. Also, most leases have renewal options in them, and even if a company lost a lease, the big land plays are over and the cost of executing a new lease way, way down. Technical problems with Shale shut-ins and hedge positions are the biggest reasons why you won't see large scale shut-ins, and the very high volume shale wells, like 4bcf+, will lose money sub $3, but not that much--so its more economical to keep flowing them when factoring in cost of shut in and refracing.


On Jun 08 01:51 PM Mmarrkk wrote:

> Why is LNG favored? Because people invested billions and billions
> into the facilities and now will run them at their ultra low operating
> cost structure and ship the gas. Once you've made a $5 billion investment,
> you have to get revenue, even if you make a very small profit margin.
>
>
> Shale gas production increasing like a flying banshee...whatever
> that means. But yes, gas production from the shales continues to
> skyrocket, even though storage is very high and prices are at or
> below the increment cost to drill, complete and operate the new shale
> wells. Part of that has to do with the expiration of leases...you
> have 3 years to drill and if you don't you lose the lease and have
> to re-lease at higher costs. So folks are drilling lots of wells
> to "hold the leases" with production. Production holds the lease
> for as long as the production continues.

Jun 08 02:12 PM

[tc1:]

With a healthy discussion here of supply issues, does anyone here have comments about the possible domestic increase in DEMAND for Nat Gas in coming years due to:
1) climate change's exacerbation of hotter summers and perhaps colder winters?
2) a possible increase of demand for use by nat-gas-powered vehicles (the T. Boone Pickens scenario), which brings up the further Q of JUST HOW LIKELY THIS DEMAND-INCREASE MIGHT BE in the near term.

For the far-term future: when the Peak Oil situation becomes REALLY intolerable, it will necessitate, i would think, a massive-scale switch to more nat-gas powered vehicles along with far more hybrids and also sugarcane-ethanol imports.

Jun 08 02:24 PM

[tuj:]

"a possible increase of demand for use by nat-gas-powered vehicles (the T. Boone Pickens scenario), which brings up the further Q of just how likely this increase might be in the near term. "

Not that likely. Fleet vehicles can do it, but average Joe cannot. The distribution network just isn't there, aside from the fuel density issues; you don't tote around LNG in a car... That means big CNG tanks with lower specific energy than petrol; not a winner in the auto world versus PHEV's. Besides, given the vol of NG over the last year, would you really want to price to that?

Jun 08 02:36 PM

[cbrev:]

A couple comments on LNG and Shale Gas:

1. While shale ng has provided most of the production growth we have seen, no one is really talking about the sharp decline rates that those wells experience after their first year of production (my guess is avg decline rates of 20-25%, sometimes as high as 45%). That coupled with the fact that land rig counts are down around 50% in 6 months, means that at some point there is going to be significant supply destruction, as there are not enough new wells coming on.

2. Shale gas production is not cheap, probably around $3 on average, with some areas with a cost of over $4ng. I think that this is/will give us a bottom in the ng market prices, as it is not economical for many operators to produce at low prices.

3. Right now, 50% of US ng production comes from wells completed in the last 40 months (Fort Worth Basin Oil & Gas publication). Think about that fact, and combined it with the current sharp decline in number of rigs drilling, as well as well decline rates, and you have a supply problem that should rear its head sometime this summer.

4. An LNG train is extremely expensive to build, some estimate around $7b. One would imagine that a pre-requisite of building a multi billion dollar plant is having long term contracts secured, so the impact of LNG is probably going to be less than bears have been forcasting.

In all, I think NG is a great long position. It looks like we have an opportunity to buy a commodity just as the pendulum is beginning to swing in the other direction. Supply/Demand should even out with an improving economy, variables are cap and trade, hurricanes, currencies, and inflation among others.

Jun 08 02:59 PM

[logicalthought:]

>>With oil nearing 70 and natural gas below four, the current ratio between the two commodities is now over 18...<<

...which is exactly why I think oil needs to come way down.

Jun 08 03:06 PM

[growser7:]

US consumed 23 TCF of gas last year and imported 3.9 TCF--down from 4.6 TCF the year prior. The vast majority were pipeline imports from Canada. LNG amounted to only 0.35 TCF and is projected to increase to only 0.6-0.7 TCF in the next few years. Offsetting this is the declining production in Mexico and Canada (the latter due to lower wellhead prices causing reduced drilling)--so imports may stay flat despite increased LNG.

Regarding shale, the decline rate is steep--aggregate Barnett production is down 20% over the past 9 months, with a lot of the wells already past the steep one-year decline curve. Same holds true for other shale plays, but as they are younger than the Barnett they are falling faster. Barnett I believe is producing ? 8 BCF a day and falling. Marcellus is hampered by lack of infrastructure to boot.

Demand destruction is the issue here; natural gas price rebound is a gamble that our economy will gear back up with increased industrial gas consumption. Supply looks like it should be tight based on the above--but a lot of operators have shut in wells and have drilled and cased wells but haven't completed them. There is a lot of gas behind pipe (PDNP) waiting for some price recovery to be put on line. It will take a while for this overhang to be worked through without a significant turn around in our economy.

cbrev, the breakeven for some of the shale plays is higher than your numbers--on the order of $5-6/mcf depending on the play. Also, these are wellhead prices not Henry Hub. (Well head is discounted rel to H. Hub). It is hedging that is keeping the rigs in the field--and that will only last so long.

Jun 08 07:02 PM

[beaux:]

Demand side comes in two forms: fundamental and technical. An economic bottom/nascent recovery will stimulate the first. Concomitant inflation fears will drive the second. All while the rig count continues to plummet. Sounds like a risk worth taking to me.

Jun 08 09:02 PM

[Mad Hedge F...:]

Maybe not. Just as I was going through this exercise last night, a long time friend from the energy industry, who used to put me up in his Dallas mansion when I was wildcatting for natural gas in the Barnet Shale a decade ago, called me up and told me I was out of my tree putting people into NG at $3.60. Huge discoveries, such as the Hainesville shale in Alabama, have made available enough NG to last the US another 50 years. The new generation of fracting technology, while great for taping into marginal, low grade fields, is much more difficult to turn off when prices are low without causing permanent damage. And then there is the looming threat of large scale LNG imports from abroad. The big gas companies will be forced to dump whatever they have on the market at any price, possibly taking prices this summer down to $2, or even $1. This, after all is the mother of all overshoot contracts. Of course, one could argue that these risks are what already took it down to $3.20, and that industry demand will happily soak up the excess supply. Did I mention that the hurricane season started yesterday? Only Mr. Market knows for sure, and he ain’t talking. In the past month, my calls have enabled traders to catch a 50% move in NG, followed by a 20% move (www.madhedgefundtrader... ). No one will think less of you if you want to cash out here at $4.30 and stay on the sidelines until a more definitive bottom is put in. As they love to tell you in flight school, there are old pilots, and there are bold pilots, but there are no old, bold pilots.

Jun 09 12:36 AM

[Shale Gas:]

Although the oil/gas ratio is at an extreme ratio, it's just as likely that oil will come down to equalize the ratio.

Jun 09 08:33 AM

[john s. gordon:]

logicalthou -

but the speculators (read goldman sachs) won't allow cost of oil futures to drop.
> jack

Jun 09 09:10 AM

[material guy:]

Liquefaction plants cost a boatload of cash and take several years to build. The only LNG plant in the U.S. is in Alaska...we won't be exporting Texas or Arkansas gas through there! In the lower 48, there are several LNG import facilities, but those just evaporate and compress gas to get it into a pipeline and cannot be just turned around to export.


On Jun 08 10:15 PM Freya wrote:

> There is also the possibility of being able to export same. LNG doesn't
> have to be a one way street if supplies are ample.

Jun 09 10:16 AM

[koolsool:]

Nat Gas is cheap, cleaner & abundant. New drilling technology has made it possible to supply our energy needs for another 50 to 80 years, even if we double our usage. It is just a matter of time until business will switch from coal & oil to natural gas powered utilities & engines. The lack of an energy plan by our political leaders is a concern. They still think there is such a thing as clean coal or a plug-in electric engine will power a semi-truck.

Jun 09 11:24 AM

[tunaman4u2:]

What do you think of the 106 build in nat gas expected vs the 124 build last week? Seems low to me, why?

Jun 09 01:35 PM

[Whippet:]

Great points. I concur.
The risk/return on this long term play is excellent given the price floor near the cost of production. And with 80% IVs on LNG, you can sell calls according to your bullishness and significantly increase returns.
Long UNG (avg. 14.50), short Jul 17 calls


On Jun 08 02:59 PM cbrev wrote:

> A couple comments on LNG and Shale Gas:
>
> 1. While shale ng has provided most of the production growth we have
> seen, no one is really talking about the sharp decline rates that
> those wells experience after their first year of production (my guess
> is avg decline rates of 20-25%, sometimes as high as 45%). That
> coupled with the fact that land rig counts are down around 50% in
> 6 months, means that at some point there is going to be significant
> supply destruction, as there are not enough new wells coming on.
>
>
> 2. Shale gas production is not cheap, probably around $3 on average,
> with some areas with a cost of over $4ng. I think that this is/will
> give us a bottom in the ng market prices, as it is not economical
> for many operators to produce at low prices.
>
> 3. Right now, 50% of US ng production comes from wells completed
> in the last 40 months (Fort Worth Basin Oil &amp; Gas publication).
> Think about that fact, and combined it with the current sharp decline
> in number of rigs drilling, as well as well decline rates, and you
> have a supply problem that should rear its head sometime this summer.
>
>
> 4. An LNG train is extremely expensive to build, some estimate around
> $7b. One would imagine that a pre-requisite of building a multi
> billion dollar plant is having long term contracts secured, so the
> impact of LNG is probably going to be less than bears have been forcasting.
>
>
> In all, I think NG is a great long position. It looks like we have
> an opportunity to buy a commodity just as the pendulum is beginning
> to swing in the other direction. Supply/Demand should even out with
> an improving economy, variables are cap and trade, hurricanes, currencies,
> and inflation among others.

Jun 09 01:45 PM

[tunaman4u2:]

How do you feel about the inventory report this Thursday... after a 124 build why are we expecting only a 106 build? Disappointment in the cards for Thursday?


On Jun 09 01:45 PM Whippet wrote:


> Long UNG (avg. 14.50), short Jul 17 calls

Jun 09 01:49 PM

[Focus Advisory:]

The north American rig count is down 52% since last year. Production is coming off in a big way and when demand crosses over, the price will go up 50% in one month.
UNG is the best risk reward trade in the market for remainder of 09.
Regards

Jun 09 01:49 PM

[Poor Texan:]

Some excellent comments here. Personally I think that utilities will substitute natural gas for coal or oil on their base load factor and use whatever is the higher priced fuel for peak load capacity. Some friction in making the move due to hedging contracts but time will eliminate those constraints.

Jun 09 01:53 PM

[Mmarrkk:]

No, can't do it. Well, you can do a little bit. Up in Kenai Alaska COP has a plant that exports. Also, some of the LNG import terminals can turn around and export the LNG they took in. But they cannot take nat gas produced in the US and liquify it and export it. It takes a very different facility and a bunch of billions of dollars to do so. And the competition is tremendous. The Qataris nat gas is almost free to produce, so the inlet of the LNG plant doesn't cost very much. Even at today's prices, $3.50 nat gas is very expensive feedstock for an LNG plant. And, there's the issue of the goofy Congressmen in D.C. They want to shut down the Kenai export plant even though we have an abundance of nat gas in the US anyway. Will never see the light of day!

Best to improve demand here in the US through nat gas cars/trucks, etc.


On Jun 08 10:15 PM Freya wrote:

> There is also the possibility of being able to export same. LNG doesn't
> have to be a one way street if supplies are ample.

Jun 09 03:19 PM

[Chris S:]

Some amazing comments here that really put this into perspective.

I'm gonna have to agree with the folks that said to correct with ratio imbalance, oil needs to come down rather than nat gas going up.

Jun 09 05:27 PM

[1980XLS:]

Gas will go up on technicals alone just as oil has.
Current chart shows flag formation indicating big move comming.

I'll guess higher, as traders move from one asset to another.

Jun 09 06:52 PM

[beaux:]

I concur with 1980XLS. Natgas will participate in the inflation trade irrespective of fundamentals. Just not until everyone looks past summer to the fall. Until then the base builds like a spring. Long Jan 18 calls.

Jun 09 08:51 PM

[Shale Gas:]

Would it be a logical conclusion that the third quarter is best for natural gas because it is hurricane season in the Gulf of Mexico, and typically there is a supply interruption?

Jun 10 08:45 AM

[harammph:]

Shale Gas is not in the Gulf.

Jun 10 11:10 AM

[zio:]

here in Italy Fiat is pumping new LNG powered cars (same models that run on oil or diesel, pretty identical power / acceleration / autonomy / car price), and so does Chevrolet with its small models (the ones formerly Daewoo). As here we pay car oil over $7 per gallon (taxes!), and gas is cheaper and the distribution network is improving, I guess they will sell... Some businesses with a large car float could probably organize their own distribution...
Also, politicians are discussing large LNG gates to be more independent from Russian gas, but also this requires time.

Jun 10 12:35 PM

[erewhonman:]

great discussion! One of the best! Thanks

Jun 10 03:49 PM

[Alpha&Omega:]

Excellent article BeSpoke! I have two questions from a very tiny investor trying to apply this type of research:

1. If you were going to take advantage of these quarterly observations, it would seen you could by options in either commodity or producers (or perhaps even midstream) in Q1 for expiration in Q3?

2. Have you done the same analysis on eitehr crude oil or gasoline that you could share?

Jun 10 03:53 PM

[Mmarrkk:]

Probably addressed this with you on another article's comments but the answer to your question on Cheniere is in the 4th or 5th sentence of my post:

"Also, some of the LNG import terminals can turn around and export the LNG they took in. But they cannot take nat gas produced in the US and liquify it and export it. It takes a very different facility and a bunch of billions of dollars to do so."

That's what Chenierre is doing...re-exporting the gas that's already liquified. Hence, no U.S. gas is being exported, just previously imported foreign LNG.


On Jun 10 02:19 AM Freya wrote:

> Mmarrkk: No can't do it? Then why has Cheniere Energy requested permission
> from the Department of Energy to do exactly that? (seekingalpha.com/symbo...)
>
>
> Cheniere is Parent of CQP whose LNG facility is almost fully operational.
> The Chairman of both has been selling LNG's shares and buying CQP
> shares.

Jun 10 04:52 PM