Is a Natural Gas Bottom Coming?

Whilst many will argue that the fundamentals for natural gas are bad, we would urge readers to note that fundamentals always appear bad at the bottom of a market; conversely, at the top of the market they appear infinitely positive. Of course, in investing the trick is to see through what is and consider what is likely to be. To be honest, we have no idea of where bottom of the market for natural gas is. However, we do know that as of late many of the signs of a bottom formation for natural gas are in place.

Perhaps we are too contrarian for our own boots at times but this is for good reason. Over the years we have learnt (yes the hard way) that “when everyone thinks alike they are most likely to be wrong”. Bearish sentiment towards natural gas appears to be at record highs, or if not, certainly at extreme levels. There are a number of reasons why natural gas prices are as low as they are (why else would they be so low?) and now we are beginning to hear how there has been a “fundamental change” in the natural gas market.

Amongst others there are arguments that the natural gas ETF UNG is driving prices (as its cousin USO is driving crude prices), that cheap supplies of LNG are coming to market, and that cheap gas supplies from shale mines are keeping the price of gas low. We don’t know what is fact or fiction, but we do know that when we hear the words (albeit words to the effect) “this time it is different” the more likely it is no different than before.

We do know that natural gas stock piles have increased dramatically over the last few months as demand appears to have fallen. However, supply cut backs have been equally dramatic. Natural gas rig numbers have fallen the most in modern history over a rolling 12 month period (a fall of approximately 56%) and there appears to be no let up in the numbers falling over the last few months. From contacts in the oil and gas drilling industry we know that the longer a rig is shut down the time to get it back on stream increases exponentially.

In addition, it is a relatively simple task to shut a rig down but it is a much more difficult task to get it back on stream. We suspect that (as per usual) operators will overdo the supply cut backs and when demand picks up stock piles will fall rapidly because supply will be unable to keep up.

From a technical perspective there has been no change in trend in natural gas futures. However, note from the chart below how the rate of change (ROC) has begun to diverge from the price of natural gas itself.

We have seen this behaviour occur time and time again in the commodities market and generally (80% of the time) it signals that the end of the trend is very near. Also note the increase in volatility over the last couple of months. Changes in trend are generally preceded by a material increase in volatility.

How long can crude oil and natural gas prices diverge in an absolute sense? Something has got to give, either crude oil prices have to fall to meet natural gas prices or natural gas prices have to rise more dramatically than crude.

Our call is that commodity prices in general have entered a bull market (click here for our discussion on the commodities market) and accordingly crude oil prices are more likely to rise over the coming weeks/months than fall. So we think that it will be the natural gas bears that give. What would be a fair price for natural gas?

We don’t know but if history is anything to go by, it appears that natural gas is trading at a comfortable 50% discount to crude.

We don’t like following the herd. Technical junkies are probably watching the $4.50 level in natural gas futures for confirmation of a breakout. We have seen enough evidence that the next move of significance is likely to be to the upside. We are positioning ourselves accordingly. It may take a few months to play out, and we may be wrong before we are right. But we can afford to wait – good things take time!

Disclosure: Long DBC, UNG, Short USO

Comments

[wturner145:]

Why not buy stock in good companies instead of stock in UNG? I would rather have one thousand shares of something real than the same amount in a hedge fund. I made money in UNG, after I noticed a good run up in share price over a month ago based on who knows and dumped the shares. Since that time the share prices has fallen four dollars.

Jul 19 08:45 AM

[Barbarous R...:]

Gas storage in the U.S. is likely to be full before the winter heating season. At that time, produced gas not shut-in will be sold at whatever the market will bear. This could mean still lower prices over the next few months. Spot of $3.00, $2.50, $2.00? Who knows?

Having said that, we've pretty much guaranteed that prices in 2010 will be much much higher. The lion's share of the U.S. gas supply comes from domestic drilling, and production is set to fall off a cliff given curtailed activity. Could production fall off soon enough to prevent storage from filling? Possible, but not likely. And any near term bounce could attract marginal supplies of LNG, thereby capping any rallies.

In my opinion, one should go long gas-levered companies (E&P or service), and hedge with a short in UNG or any other gas futures driven ETF. The company stocks will likely look through the valley, while the ETF could get punished in the near term. The stocks are also poised to outperform on the upside when things appear to be turning. Best gains will be had in the most levered debt ridden companies (provided they can survive the next 6 months or so).

Jul 19 10:35 AM

[Mad Hedge F...:]

This is the second most forecast bottom after real estate. When I put out my sell recommendation on natural gas at $4.30, the virtual trucks backed up to dump abuse on me from technical analysts, day traders, and wannabe pundits who were convinced that CH4 was the buy of the century. I also received a ton of e-mails from geologists, wildcaters, and gas men from all over the country with stories of even more, vast, unreported, shale discoveries. One in British Columbia I didn’t even know about. When it comes on betting my own money, I much prefer listening to engineers who spend countless hours driving pickups down dusty, potholed, washboard roads to get their data, than the online diletants, any day of the week. Best to watch the pain and suffering in the natural gas space from afar.

Jul 19 11:56 AM

[jeandit75:]

Nope, let's keep it simple. NG storage is about to be nearing full capacity in Alberta, Texas, and California. Demand (excluding the seasonality where summer hot days stimulates high demand) is still remaining at very low level in most states. There will therefore be a destocking phase before we can see higher prices. My guess is NG going to $2 before it can form a base to then move higher.

Jul 19 01:15 PM

[H. T. Love:]

On Jul 19 01:15 PM jeandit75 wrote:

> Nope, let's keep it simple. NG storage is about to be nearing full
> capacity in Alberta, Texas, and California.

And don't forget CIG's OFO (Operational Flow Order) issued three weeks ago (and mentioned again in the EIA weekly report two weeks ago) that informed customers with interruptable contracts that no more injections will be accepted and interruptible contracts with gas already in storage must get it out by 7/31. As far as I know, nothing's changed, but I think I remember they are trying to open new storage in that system.

> Demand (excluding the
> seasonality where summer hot days stimulates high demand) is still
> remaining at very low level in most states. There will therefore
> be a destocking phase before we can see higher prices.

Yep, looks like Joe Bastardi (Accuweather) was right so far - milder than normal summer, especially in the Northeast areas.

Further, NOAA (the only forecast I could find for coming winter) projects normal to slightly warmer winter temperatures for the middle 50% of the U.S. (a vertical band).

> My guess is
> NG going to $2 before it can form a base to then move higher.

Did you see the latest in the EIA weekly? "Natural gas rotary rigs fell ... Despite this week’s decrease, the pace of recent declines in rigs appears to be slowing".

I suspect that in order to not lose their leases, among other reasons, drillers are loathe to close them all down.

I really hope it doesn't go that low - I'm afraid we'll lose a lot of co.s if it stays there too long and then we have severe shortages at the worst possible time. Thinks seem to work that way - "The Worst Possible Time" principle.

HardToLove

Jul 19 05:21 PM

[H. T. Love:]

"Whilst many will argue that the fundamentals for natural gas are bad, we would urge readers to note that fundamentals always appear bad at the bottom of a market; conversely, at the top of the market they appear infinitely positive".

That sure sounds like something the sell-side says. I'm a n00b and I published my first article 6/18 (authored 6/4 originally) that said it was going down. My point being that fundamentals looked terrible to a n00b like me then and I've seen so many "Is NG bottom ..." since then I'm *sick* of them. So why are all these articles appearing now when even *I* can see it's many months *at_least* before we see the bottom.

Disclosure: nothing to sell, made profit in UNG back in June and hold nothing energy related now. But I'm working on a bull case - just taking a long time to find "green shoots" that fall with a reasonable time-frame (like my lifetime? LOL).

HardToLove

Jul 19 05:29 PM

[erewhonman:]

Trading based on rig counts may get one in trouble. Over the last few years the amount of gas discovered per rig has climbed significantly so that far fewer rigs are required, particularly in the new shale plays.

Jul 19 07:06 PM

[User 60967:]

If Bastadi said a milder than normal summer for the Northeast, he is wrong. CCD in Boston are 40% less than normal (6/1-7/19). NOAA/NWS are talking about an ElNino this winter, but I wouldn't bet the farm on their record. When long term forecasts give a slightly above or below normal trend, it's basicly flipping a coin.


On Jul 19 05:21 PM H. T. Love wrote:

> On Jul 19 01:15 PM jeandit75 wrote:

Jul 20 07:27 AM

[Jim98:]

I am looking at buy and hold on this one over a few years. Any opinions as to the best few stocks in this space? Thanks.

Jul 20 10:32 AM

[NGAnalyst:]

I'd say that fundamenally I start seeing a bullish turn in gas market, which we had not seen in almost a year. The question remains now is whether or not the improved balance will overcome the bearish pressure from storage overhang and lack of near-term weather --- within the next 100 days.

Rig counts vs gas output is always a mystery to me. But I tend to believe that it is the producers who know their own game best, and having said this, I am actually bullish to see that rig counts have been bottoming out.

Jul 20 11:56 AM

[H. T. Love:]

But the depletion rates for the shale wells are *very* high. I seem to recall that in 12 to 18 months it has dropped so much that those wells become marginal (but don't hold me to that - I read so much that I could be getting confused). Anyway, if I'm anywhere near close, it won't take long for the reduction in drilling rigs to start to show reductions in production substantial enough to cause price rises based of fear of future under-supply.

But I do believe either a harsh winter or a time-frame of very late this winter will need to be seen before it really gets prices moving substantially. But I've not finished running my analysis on my next article yet - this is just "gut" feeling for the moment.

HardToLove

On Jul 19 07:06 PM erewhonman wrote:

> Trading based on rig counts may get one in trouble. Over the last
> few years the amount of gas discovered per rig has climbed significantly
> so that far fewer rigs are required, particularly in the new shale
> plays.

Jul 20 01:37 PM

[BigOlDave:]

Good article. At these prices, power companies with options are burning nat gas, not oil. Nat gas will soon have more environmentalists declaring their support for it too.

Nuclear still makes the most sense, but has no champion.

Jim98 asked, "I am looking at buy and hold on this one over a few years. Any opinions as to the best few stocks in this space? Thanks."

Jim98: Never "buy-and-hold" -- that's an RX for neither wealth nor peace of mind. "Homework/Buy low/Homework/Sell high" is the formula. It doesn't always work for me (remember: this HAS been the worst recession since 1929), but I consistently beat the S&P500.

Opinions: I like the MLPs and own EV Energy Partners L P (EVEP) and Energy Transfer Partners (ETP). These are the kind of "partners" you can get into bed with, but NEVER fall in love with. I'm in this game for the money.

In a flat market -- which is where I expect to see for the next 6 months -- yield makes you a winner.
EVEP = 15.3%
ETP = 8.1%

I expect their share price to hold steady thru 2009.

You're welcome.

Dave





Dave

Jul 23 04:14 PM