Natural Gas Is a Trade, Not an Investment

| About: The United (UNG)

Don't be shocked that this article is shorter than what might be normally seen from me. I'm foregoing my normal detailed description of all the factors I've considered in favor of a few charts. Most of my considerations have been aired in either other articles or comments to articles from others.

SUMMARY: If your horizon is long enough there is an investment opportunity here. However, if you consider the opportunity cost as part of your deliberations, you might decide that investing when some real positive signs of near-term improvements appear would be a better strategy. Currently there are no near-term positive indicators.

CONSIDERATIONS: I'm sure everyone interested in natural gas has been waiting with bated breath for the expected turnaround in natural gas prices. However ...

Natural gas recently priced at 7 year lows and I see no relief in sight through the intermediate term. Today, September 3, the October futures contract was at $2.508 at 16:17. Storage is 18% over 5 year averages and way above the high side of that 5 year range. New rigs have been added consistently over the last six weeks and net injections have been within normal ranges, although at the low side the last few weeks. There is a strong possibility that all storage capacity will be used before the end of October, according to the EIA.

In the past, there has been speculation based on:

  • The oil to natural gas price ratio (severely broken),
  • The oil to natural gas energy content ratio (doesn't matter much without infrastructure and demand supporting increased consumption),
  • The fact that it's "home grown" (should be "home groan" in this case) will promote its use to get off dependency on foreign oil (really meaning increased transportation use - without infrastructure, how?),
  • Exciting new legislative action to provide incentives for increased consumption (will the clowns come out with more jokes or do something serious for a change - "clean coal", "wind" and "solar" has been their mantra until now),
  • Recent DOE support for increased commercial re-fueling stations ($100,000/station - what's the cost to build one? Will this amount really help that much?),
  • Pipe dreams that we could certainly begin converting private automobiles to natural gas shortly (but commercial must be done first because they can justify the cost via a business case and that's what will stimulate the infrastructure build-out), etc.

Well, in the long run, I think natural gas will be a stronger component of our energy consumption. But for now fundamentals rule. Let's look at some things related to, or which might affect, fundamentals.

We have some legislation promoting increased use for transportation in process but that probably won't yield results for a couple of years. Transportation usage is currently less than 2% of total consumption and any increase will take a long time to be even noticeable.

Electricity generation is a good candidate but we need, again, improved infrastructure. We also need to overcome the hurdles of state regulation to pass the capex on to consumers, as well as a business case to convert from coal. Since the BHO crew talked so much about "clean coal" and barely ever mentioned natural gas, we have to wonder about the impetus for natural gas (as well as the intelligence of the BHO crew) in this arena.

With GDP capacity utilization currently at 68%, we can't count on industrial or generation use to bring demand back soon. Reduced import and export activity is reducing the use at ports for drayage and use for shuttles and metro-transit systems is being curtailed by bad the economy.

Still not convinced that one should wait to "invest"? Look at these charts.

Take a look at the current storage situation, from the EIA report of September 3, 2009. Click to enlarge.

EIA Storage Report September 3, 2009Click to enlarge

And how about those rigs that everybody was hanging their hat on? Yeah, they are down but not still going down. In fact, they've been rising consistently for about six weeks now. Click to enlarge.

Baker-Hughes Natural Gas Only in 5 Year GroupingsClick to enlarge

Even with the current Baker-Hughes natural gas rig counts at 2003 levels and two major players announcing cessation of new on-shore E&P activities due to low prices, it will take a long time to work off the excess supply in storage (currently over the high side of the 5 year average by 18%, per the latest EIA report). Rigs continue to be added, although we don't know yet (I've not checked the EIA monthly for this yet) if the rigs are exploration or development. Even if I checked the reports they are not that useful since the report runs a couple months behind.

With storage 18% over the high side of the 5 year average and 68% GDP utilization, we can anticipate that it will take 1.74 times as long as it would have in the recent past (presuming no major changes in the scenario) to bring storage, demand and supply back into balance after production ramps down to more appropriate levels.

That leads into production considerations. Click to enlarge.

Natural Gas Average Monthly Production 2005-2009Click to enlarge

Even with rigs counts at 2003 levels, storage bursting at the gills, demand down, modest GDP growth predicted and price in the tank, they just keep on producing. Look at the last bar for June. It's right up there with other months in the last year-and-a-half. If the trend continues, there won't be any noticable drop in stored quantities for some time.

Heaven help the producers and storage operators if we have a mild winter and/or the predicted recovery gets delayed!

Either it's gotten really, really, really cheap to produce this stuff or the producers are being driven by elements other than near-term realized prices. Of course, the futures contracts are in contango, so maybe they are hedging and can still make money, after contract costs, since contracts through June of next year range up to $5.08.

But the real contract volume, that we might expect to see if hedging was going on, only extends through the January contract, currently $4.81. Depending on who you believe, that may work. I've seen cost of production estimates that range from below $2.00 (Texas I believe) to $6-$8. I don't know what to believe.

Now if they can only find some place to store it.

At any rate, whoever is bearing the cost of storage may eat some costs since I expect that the normal seasonal rise will be severly muted. Check the way prices normally change in the following chart. Note that the "left" month is October. I did this because I felt it highlights the most consistent start of the upward price trend. Click to enlarge.

Monthly Reported Prices 2000 through June 2009Click to enlarge

What's not apparent from this chart, since the EIA reports several months behind, is that the price even back in June was approaching 2002 levels and, as I mentioned above, they are now in the $2.50 range - well into the 2002 level. I guess I should wonder what today's price is in 2002 dollars. Anyway, since I've been following the progress on this stuff, I can tell you that it has continued to trend down consistently and I feel it will continue to do so unless a major catalyst is encountered.

I do expect a flattening of the price trend late this year or early next, depending on weather.

CONCLUSION: Regardless of the vehicle you choose - E&P companies, majors, energy ETFs, etc. - they all have the same natural gas product as part (or all) of their portfolios. You don't want to buy them based on near or intermediate term expectations for natural gas prices since they are not likely to substantially contribute to corporate profitability. If you know them to be hedged at higher prices, you can safely jump on them.

Before anyone asks, UNG is not an investment, only a trade. See my and others' various comments, instablogs, etc. for assessments of why. UNG has deteriorated to where I say don't enter UNG now even as a trade. Wait to see if it gets its issues regarding CFTC limits resolved satisfactorily and can eventually track natural gas prices reasonably well with a reasonable expense ratio. The premium over NAV (Net Asset Value) is high (double-digit percentage) and NAV will deteriorate with the price of natural gas and with the expense of roll-over, due to a severe contango. Roll-over is scheduled to occur September 14-17.

Disclosures: Long UNG (from before its current problems) long puts on UNG short calls on UNG.