We've asked it before and we'll ask it again: What is up with natural gas these days? Stockpiles are at all-time highs and prices near their lowest point in years, and yet natural gas ETFs like the U.S. Natural Gas Fund (NYSE Arca: UNG)—now trading at a whopping 20% premium—just keep climbing. What gives?
It comes back to demand—or the lack thereof, says Christopher Jylkka, principal and manager of Boston Energy Trading, LLC and regional director of energy market intelligence firm Enva. With over 12 years' experience in the energy industry, Jylkka is an expert in the trends and fundamentals currently shaping the natural gas markets.
This week, HAI Associate Editor Lara Crigger chatted with Jylkka about natural gas, including the problem of winter storage space, whether the contango will continue and the alternatives to UNG.
Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): Lately, we've seen record stockpiles of natural gas, and some people predict we may run out of winter storage space. Do you think this will happen?
Christopher Jylkka principal/manager, Boston Energy Trading, LLC; regional director, Enva (Jylkka): I do, and here's why. Most of the remaining storage capacity is controlled by LDCs, or "local distribution companies." These LDCs are either investor-owned or public gas systems [owned by the government]. LDCs are usually trading hubs, so the wholesale gas goes to the LDC point, and then from there, it goes on to the consumers.
Most of the storage capacity is controlled by LDCs, not producers. Producers really don't have control over what goes into storage. In the East, where most of the unused storage capacity lies, that is controlled by LDCs, who have to report to a public utility commission on their rates and the timing of their injection. They can't just look at the market and act, if they think they can get a better deal next month. They file their injection plans months, sometimes even a year, in advance.
So just because there's plenty of room in the East doesn't necessarily mean we won't have an overflow problem, because people in the producing regions in the West—the most full region of the country—can't use that storage. It's controlled by the LDCs. That's why you have gas being so much more volatile than almost any other commodity, and you have electricity being even more volatile, because of the storage issues around it.
Crigger: How does that affect natural gas pricing?
Jylkka: If storage does fill up—and it is on track to do that—these next five weeks or so are going to be very, very interesting. It will affect prices violently.
September is the lowest-demand month for natural gas, and it's also the lowest-demand month for power. September is maintenance season for power plants all over the country. You also have industrial demand, which is about 30% of total gas demand. Refining is a big portion of that, and September's also refining turnaround season as well. So gas demand's going to be very, very low, which is just going to exacerbate the issue.
So if it does happen, and we do run out of storage, it could drive natural gas to $1.00 or even lower. I'm not saying we're going to get there. But if all the stars line up, it could get really ugly. People look at historical charts and say, "Well, gas has never been this low, and the oil/gas ratio has never been this extreme." But it can always get more extreme.
Crigger: It sounds like there's really no hope for a turnaround anytime soon.
Jylkka: Yes, and we're in the peak of hurricane season, too. In fact, I think today [Sept. 9, 2009] is supposed to be right around the peak of hurricane season. So it's really all downhill from here. Every day that goes by where there's not a threat, there's less probability of a supply disruption.
This has been the year of anomalies in all sorts of ways. One thing that could potentially save prices is if some people can and will defer production, because there's a steep contango in natural gas futures. I don't know how many of them can or will do that. There's no evidence they're doing it yet. But that could slow it. That could help.
Of course, if you do see a collapse in the spot price of natural gas, that contango will steepen even more. Because when the spot prices collapse, they'll take the front month with it. That will wipe out some of the marginal producers, which will actually be bullish farther out. So you would see that contango increase a lot if this happens. I'm not sure of the probability of it happening, but if it does, then you'll see the contango strengthen.
Crigger: As we head into the winter heating fuel season, do you think we'll see a pickup in gas demand?
Jylkka: Yes, but I don't think it will make much of a difference. One of the major energy weather services I follow says they think an El Niño pattern will persist into the winter; if it's of moderate strength, then the Northeast—where you get concentrated gas demand in a cold spike—will have a mild winter.
So even if we avoid the containment issue for the next five or six weeks, we're still going to be at a very high level of natural gas inventory. So I think there could possibly be a spike, but it would be short-lived. It's going to take awhile to work off this oversupply.
Crigger: How long is "awhile"?
Jylkka: A year, I think. It depends. The wild card is really the global economy, and how that picks up. Or doesn't.
Crigger: So what are the differences between the supply/demand characteristics of natural gas and crude oil?
Jylkka: Natural gas and crude oil have historically been correlated for a long time. But a couple things recently have changed the structural relationship between the two. The biggest one is really the way markets have evolved. Oil is truly a global market now, but gas is very domestic. Everyone talks about LNG, but it's really only 2-3% of the supply. It's not growing as fast as a lot of people say. Natural gas is truly a domestic marketplace.
Also, the cost of storage is very different. Gas is much more difficult to transport, with LNG being a great example. Consider just the energy needed to compress it, liquefy it and transport it across the ocean.
Oil and natural gas tend to be correlated when supply and demand is tight for both products. If you have a loose supply-and-demand balance for one, you lose that correlation. A lot of people have been fooled by this. And another thing is that gas is finding new uses, while oil is not. Transportation in municipalities, converting bus fleet to natural gas is a good example of that.
Crigger: So how will lower natural gas prices affect industry in the next few months?
Jylkka: It's going to be great for some people and bad for others. I think it'll be great for fertilizer and ammonia companies, which really suffered last year when gas went to $12-13. Eighty percent of these companies use that ammonia to make fertilizer, so lower prices will benefit them greatly. And of course, it's going to benefit consumers, too.
Who's it bad for? Exploration and production companies. It's bad for drilling contractors. It's bad for oil servicing companies, mineral leasing companies. It's bad for tax revenues. Definitely there are more bad implications than good. And it reinforces the commodity cycle, I think. You get a collapse, which is going to pave the way for another part of the cycle.
Crigger: Switching gears, I wanted to get your perspective on the CFTC's proposed regulation of the energy markets. Do you think we need position limits in energy trading?
Jylkka: I'm a free-market guy, so it does rub me the wrong way. I think position limits done the incorrect way could be much more damaging; for example, setting different limits further out on the curve, where you'd have different position limits on the front month. Well, you're just going to drive people farther out on the curve; they'll just do stuff in 2010, 2011.
Also, if you force people into position limits, you're going to force people to do more bilateral transactions, which are the side bets or the dark markets. It could even force trading overseas to different exchanges. And it will reduce liquidity. Everyone knows that speculators provide liquidity. It will also increase volatility.
Crigger: We've already seen some ETFs closing down as a reaction to regulation, like what happened with DXO. If position limits were put in place, do you think commodity ETFs would lose their competitive edge?
Jylkka: Recent history is troublesome. You've got UNG—which is behaving like a closed-end fund—trading at a 20% premium to its net asset value. I mean, even if it didn't have a premium, it's risky for long-term investors, and you add that on top of it all? It doesn't look very good.
If you have regulatory uncertainty, people just aren't going to go to it. I think this is a real issue for ETFs.
Crigger: What are the available alternatives?
Jylkka: Not much, if you're trying to replace UNG. UNG just invests in the front month, so you can find some discretionary managed futures program with someone with exposure to the spot month. But the minimum investments are around $25-50K, which prevents many people from getting into that.
You could try the MLPs, or even try to find an unhedged natural gas producer, which is very difficult to find these days. When gas was going up, a lot of people would tell investors they were unhedged; now, of course, if you say you're unhedged, it doesn't look very good. And then there are index funds as well, but to be honest, I don't think there's a good substitute besides managed futures at this point in time.
Crigger: So should futures-based funds like UNG go off the market? It sounds like that will really force the retail investors out of that area, too.
Jylkka: Yes, I think it's problematic. When funds stop issuing new shares, you know there are two problems. One, the fund becomes too small, so it costs too much to transact with them, and your liquidity suffers. Or two, if it gets too big, you know they have this huge long-only position somewhere. Some of these energy markets are very small, and I believe it can have a very distortional effect in the front month.
