Rough Times Ahead for Natural Gas

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.

Comments

[NGAnalyst:]

On UNG, unless you trade futures, it is still a good way to invest in natural gas. Sure, it won't capture all of the profit in a contangoed situation, but it still gives you nice chunk of the bullish trend. The premium bothers me as well, but hey, as of this morning, the premium dropped to below 10% for a short time!

What this premium really means is that it exaggerates things on both sides -- it hurts when there is a downturn in gas prices, but also remember that it helps when there is a upturn as more people try to come in.

Sep 11 10:55 AM

[Elliott:]

Working gas in storage is 500 Bcf above normal and producers continue to inject more at the rate of 60 to 70 Bcf a week. Storage usally peaks around Nov 1 and then is drawn down at approx rate of 450 Bcf per month during winter. Just to draw down the excess in storage is probably going to take until December, even longer if we get the expected mild El Nino winter.

Sep 11 12:10 PM

[Smrt1:]

Wow Dude, you really need to stop copy and pasting your own commments over and over and over again into every article you see. I have seen this same quote from you at least 15 times in the last week.


On Sep 11 09:49 AM Mad Hedge Fund Trader wrote:

> mnh. Just when I get comfortable with my view on Natural Gas, I get
> a scratchy, reverberating cell phone call from one of the major formations
> telling me that I’m being way too bullish. Gas won’t bottom at $2.
> The free fall will continue until it hits $1. National storage will
> be completely full imminently top out, and when it does, theproducers
> will have to shut down completely. Since these guys are leveraged
> up the wazoo, this will trigger a string of bankruptcies, and the
> majors will fall like dominoes. A hedge fund bust won’t define thisbottom,
> as these guys are all playing from the short side. UNG can’t step
> in as a buyer of last resort, as the SEC won’t let it issue morestock,
> and the current shares are trading at a ridiculous 20% premium.One
> thing we do agree on is that the bottom will look ugly, whatever
> the spark is. You often get Armageddon type views near market bottoms,but
> this guy has been dead on right until now. Well, it takes two to
> make a market. Conclusion: keep NG nailed to your screen, as the
> widow maker is where the volatility lives.

Sep 11 12:11 PM

[AndrewBaker:]

What's the difference between trading in natural gas futures and betting in a casino? There is none.

The most well reasoned arguments to do with natural gas do not correlate with the price movement. Right now there are a lot of gamblers in this market, so choose your trend direction with a coin.

I'm long. This is just too oversold and underpriced and has to head north from here.

Sep 11 12:35 PM

[ETETET:]

Record low NG prices start forcing smaller/ highly leveraged companies into filing for bankrupcies. If prices stay low, the situation for gas producers will get worse. Storage vol. may gradually decline because of fewer producers, involuntary cut back on production, or an increase in consumption.

www.statejournal.com/s...

Sep 11 01:16 PM

[Ron2008:]

Excellent article. Thanks.

Sep 11 02:21 PM

[Kisei:]

MCF is good alternative unhedged way to play natural gas. 355 Bcf of proven reserves and not much else

Sep 11 05:28 PM

[User 422955:]

UAE connect. How can you protect your clients from a"major Middle East conflict or war."?? Do you sell body armor, bomb shelters, or what?

Sep 11 09:05 PM

[JCC:]

Interesting to read this article and the various comments. Natural gas is down, because supply is up dramatically. We found that when we tried to extract shale oil, we did not get much oil, but we ended up with a lot of natural gas. So with the increased supply and the fact that there is plenty more to extract prices will be down until we increase usage.

This of course has changed the equation, and it makes a lot of sense to start a gradual shift to using LNG as a transporation fuel. This would dramatically reduce oil imports, and we would be burning a cleaner fuel. This makes so much sense, that I am hopeful that the markets will eventually lead us in this direction.

Sep 11 09:09 PM

[dcb:]

october gas is trading 30% above spot prices. you need to gigure out when the roll over for the funds are. you do not want to be in funds during roll over when futires are higher. this causes an immediate 30% loss

Sep 12 05:36 AM

[buyitcheap:]

DXO was an ETN and was always meant to expire. It had nothing to do with regulation.

Sep 12 08:35 AM

[Aricool:]

Re DXO. I saw the CEO of USO that said DXO closed because the transaction costs of doing the contracts got too expensive lately and was not because of pending legislation. I DXO only got a very small fee so it was no longer profitable. Actually, this is confirmed by the fact that USO is now reported to be offering shares again.

Sep 12 12:23 PM

[The-Stock-M...:]

Not trying to pat on my own back here, but I wrote last weekend about this expected price action in UNG:

seekingalpha.com/artic...

I compared prices with that of oil near its lows, and urged folks to accumulate shares at these prices, and my predictions came true in the same week, UNG rebounded, and rebounded big! The pros are always working overtime to catch the small-time traders by surprise. My humble advise to the small-money traders, play only with options, so that at least you lose only the premium and not your entire trading principal...

Sep 12 12:39 PM

[Genesis:]

Please tell us about "underlying fundamentals"... otherwise these are just empty words.

"prices running up so fast" - You're referring to the short covering?

On Sep 11 10:47 AM NGAnalyst wrote:

> One thing that a lot of people have missed is that --- underlying
> fundamentals are improving rapidly, which means we will most likely
> not have a storage congestion issue by end of Oct. This is the reason
> why we have seen prices running up so fast. As long as we don't finish
> sustainablly higher than european prices (~$4), I am not surprised
> to see prices going even higher.
>
>

Sep 12 01:22 PM

[Genesis:]

With that attitude toward investing, you might as well just go to Vegas. At least you will have a good time while losing your money.


On Sep 11 12:35 PM AndrewBaker wrote:

> What's the difference between trading in natural gas futures and
> betting in a casino? There is none.
>
> The most well reasoned arguments to do with natural gas do not correlate
> with the price movement. Right now there are a lot of gamblers in
> this market, so choose your trend direction with a coin.
>
> I'm long. This is just too oversold and underpriced and has to head
> north from here.

Sep 12 01:26 PM

[Gigem77:]

UNG is a flawed vehicle. It trades at a premium to the NAV. UNG announced yesterday after the close that they were issuing more shares. That may not be enough to eliminate the premium, but the price dropped after hours to 10 bucks. The October natgas contract terminates trading on Friday, September 25th. "UNG’s investment strategy is to close out its positions and ‘‘roll’’ from the near month contract to expire to the next month contract during a four-day period beginning two weeks from expiration of the contract.” How many contracts will they close into the biggest glut of natgas in the last 20 years? Don't let the 2-3 day short covering rallies fool you into thinking the low is in place. Canadian natgas is projected to go below a dollar before winter and the US spot price for natgas is easily headed below 2 bucks.

Sep 12 01:29 PM

[Aricool:]

Hi, good article. Two questions come immediately to mind re your LNG statements copied below.

I'm very concerned about the long term pricing of NG. I'm trying to see it as bullish as you do, but many long-term factors seem like it might keep it very low- not the least of which is LNG imports from Russia and Arabs when NG gets back over $4.

Have a look at the LNG import spike between end '06 and early '07 and it tracks *exactly* with a step down of NG price from 7 to 5. This is insane that LNG could crush prices during a robust US economy. I'm very scared now that with the paltry 2% trend growth expected for the US (and EU?) going forward that they'll dump excess Euro LNG onto the US and repeat that '06/'07 event. This would almost certainly keep NG prices under $4 in the expected weak situation for '10. This is a huge uncertainty in playing '09 weakness esp. if buying into NG driller/services securities to play the "perfect storm" against NG. That is, the LNG would dump just enough supply to easily keep the storage full, thus keeping NG exploration and cap ex down to a minimum, and b/c most NG producers are only partially hedged for 2010 (maybe 30% or less?) then they would get killed in 2010 making there hedged supported stock prices 2009 quite high. This uncertainty really sucks! Can you discount this scenario?

The EU is expected to recover more slowly than the US so why (in the context of those reports/articles I sent you) won't the LNG plays dump what ever they can on the US. As I analyze the charts, the LNG chart tells me a very bad story. That is, the June '09 LNG was sold at only ~ $4.3 while volumes where a little above that just before the '06 event (see above) when NG price in '06 was ~7, and then dumped 2X the volume for 6 months and were more than happy to collect only $5 in that time. Again, this was when the EU and US were heading into a peak earning cycle. This tells me that the LNG players will keep US NG prices in the toilet (<$4) until the US (and EU?) are in a full recovery. Very, very bad for NG sector stocks for 2010. Please debunk this gloom and doom scenario! It seems all too possible if the magal V-shape recovery does not materialize in early 2010. Hence, why with a weak EU they'll dump there LNG at a (double? june '09) high rate and keep the US storage near max, thus NG prices in the toilet.

I'd really hate to additionally bet on a V-shape recovery on top of the structural NG risks I've discussed. There are much more (risk adjusted) profitable bets on a V-shape recovery in the market.

Betting on a V-shape recovery is over the top for a NG bet at this point.

NG prices seem destined to go well under $2 well into November, and while it may rebound next year LNG will keep it near $4 and kill/hurt most US NG producers until the economy fully recovers (1-2 years) and get NG price in the $5-6 range.

So, you can try catching a falling knife or put your money in soaring NG stocks which will collapse next year when there hedges are gone and NG is kept too low b/c of LNG.

Seems like NG is a bad bet until at least Nov.



==============Your article said:
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.

Sep 12 02:29 PM

[Aricool:]

2nd LNG question re "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."

Do you happen to know how much all the LNG overhead/logistical costs (per mcf) amount to in the end, at the US delivery point? We can assume LNG from Russion has no production cost b/c it is a byproduct of oil production.

thanks!

Sep 12 02:39 PM

[Aricool:]

AndrewBaker,

Why can't NG go under $2? If most of the producers are 100% hedged for '09 (hence likely why their stock prices are not in the toilet w/ NG price) and they have to produce to keep their valuable land leases and we have a 100 year supply, then why stop production at any price when you're getting top (hedged) $ any how??? Someone needs to explain to me why will they given these (and many other simar) factors.

Besides, did you notice that rig counts bottomed in early June and actually started to uptick in July-Aug. Also, day rates never came down enough. Not a good sign if you believe in major production cuts.

The current pop up is just massive short covering and rabid bull sector rotation desperation. Why can't Nat Gas (NG) go under $2? If most of the producers are 100% hedged for '09 (hence likely why their stock prices are not in the toilet w/ NG price) and they have to produce to keep their valuable leases and we have a 100 year supply, then why stop production at any price when you're getting top (hedged) $ any how??? Someone needs to explain to me why will they given these (and many other simar) factors.

Besides, did you notice that rig counts bottomed in early June and actually started to uptick in July-Aug. Also, the fact that rig day rates never came down enough tells you drilling did not drop enough. Not a good sign if you believe in major production cuts.

Also, if you look at the last recessions NG droped to around $2.5-2.7 in real terms (adjusting for inflation); however, that was when US NG production was believed to have peaked, which is why we later created infrastructure for LNG imports- and those lows were before we became the Saudi-Arabia of NG with massive supplies. So, it would stand to reason that we'll see below $2 easy; esp. since we got so quickly to $2.5 w/o resistance.

Moreover, I'm very concerned about the long term pricing of NG. I'm trying to see it as bullish as you do, but many long-term factors seem like it might keep it very low- not the least of which is LNG imports from Russia and Arabs when NG gets back over $4.




On Sep 11 12:35 PM AndrewBaker wrote:

> What's the difference between trading in natural gas futures and
> betting in a casino? There is none.
>
> The most well reasoned arguments to do with natural gas do not correlate
> with the price movement. Right now there are a lot of gamblers in
> this market, so choose your trend direction with a coin.
>
> I'm long. This is just too oversold and underpriced and has to head
> north from here.

Sep 12 02:52 PM

[aarc:]

When everybody and his/her dog is bearish on UNG, then the bottom is not too far away.

Natural gas price is also affected by the season rather than storage and September to October seems to be the most bullish months for NG. Just look at the charts spanning several years for NG, NG price tend to rise even during multi-month downswings and not only during upswings during these two months.

Also the NAV just kept on rising for the last few days going from $7.xx (if my memory serves me right) to $9.12 while UNG goes up from 9 to 10.50; so the much maligned 20% premium has narrowed down to 13% even if UNG price went up last week since NAV rises faster than UNG. At the rate NAV price is going up, the premium can go zero if UNG stays put due to the dampening effects of the issuance of new shares.

If you roll over NG contracts from Oct to Nov, then there is a contango of around 26% and you will have to pay that premium. If the price of of NG does not go up and actually settles down to the previous month's price (as what initially happened to Sept-Oct contract on the first 2 weeks after rollover) until the Nov contract expiration, you lose 26%, plain and simple.

Now, the 26% contango for the roll-over is not actually 26% loss for UNG since UNG holds $3.65B in CASH, only $1.20B for NG and NN futures; the rest are in swaps. From the current ratio of Futures/Cash alone, the actual loss for UNG playing the NG/NN contracts can be only 1/3 of 26% or 8.7%. That is a lot smaller loss than trying to play the NG/NN contracts themselves assuming price of nat gas remains constant througout November.

Come January to February NG contracts for 2010 and the contango goes down to 1.34% and goes much less than that for succeeding months next year. That is a dramatic reduction for UNG losses every roll-over. Who knows, backwardation might kick in before 2010 is over and UNG will gain every roll-over dates possibly wiping out all those losses during the contango year of 2009 by 2011/2.

Looking at the monthly charts of NG; NG is definitely a cyclical commodity that goes up and down with an almost predictability like a sine wave despite the US having more than 100 years of reserves and production will almost always exceed demand since the demand is local and miniscule as compared to the massive proven reserves.

Producers will simply kept going bankcrupt at the rate they are trying to kill each other until only a few will stand and be able to control production as well as the price of nat gas.

Stop thinking linear; the price of NG goes like a sine wave.

Sep 13 08:37 AM