What's Driving Natural Gas?

Includes: GAZ, UNG
by: FP Trading Desk

Despite the bearish backdrop for natural gas prices due to rising inventories levels, supply exceeding demand, and the emergence of prolific lower-cost shale plays that are flooding the market, the past couple of weeks has been surprisingly good for the commodity.

From its Sept. 4 low, Nymex natural gas futures for October have risen more than 35% to roughly $3.60 per Mcf. The Henry Hub spot price has done even better – up 75% to $3.21 per Mcf.

And experts say the volatility has not been this high since 2006. But companies, clients and experts in research, trading and commodities are scratching their heads in search of answers.

The recent bullish price moves could be explained by a number of factors, according to a report from RBC Capital Markets.

  • Supply: Liquefied natural gas (LNG) flows may not flood the U.S. and domestic production could fall swiftly because it is not sustainable at current activity levels.
  • Mildly positive natural gas storage injections recently could point to improving economic-based demand.
  • A long-term weather pattern with a lack of sun spots appears to have developed, which means we could move into a period of global cooling and higher winter heating demand.
  • There could be some short covering going on as lawmakers push for curbs of speculative trading in commodities.
  • Long-term value: With sustainable natural gas prices between $6 to $7/Mcf, the trade looks good despite near-term uncertainty.

RBC analysts also note that the consensus was generally bearish on gas for the near term, but supportive of prices at $6 or higher in the second half of 2010.

There seems to be a confluence of fundamental and technical events driving prices higher in the short-term, but no certainty as far a one or two reasons, the analysts said. They think there is a real risk that natural gas could re-test the $2.50 Mcf level again over the next month since storage levels could be maxed out.

“That would cause a lot of pressure on near-term prices as gas-on-gas competition will be significant,” the RBC analysts said.

“In the event that storage fills to capacity, the spot price would collapse as the gas would be essentially worthless,” Research Capital’s Ken Lin said in a report.

For the last six to nine months, people have continually expected the reduction in capital expenditures to reduce supply enough to rebalance the market, the analyst noted.

While current prices are unsustainable since they fall below full cycle replacement costs, he thinks those calling for a recovery may be doing so for quite a bit longer.

The analyst agrees that the longer-term prices for gas are attractive due to factors like increased use for electricity generation instead of coal. However, he expects disappointing results for the third quarter as he forecasts very little drilling activity will occur.

Ultimately, the lack of drilling activity in the natural gas space is expected to diminish supply and close the very wide spread between oil and gas prices.

Mr. Lin recommends investors focus on the names that can survive an extended period of weak natural gas prices, as well as those that have low operating costs and high netbacks to cushion against low commodity prices.

He said:

Barring a significant recovery in industrial demand, the reality is that there is simply too much supply if every company was still on a growth mandate. There will be a period when some of the weaker players are consolidated or disappear, but longer term, natural gas prices will recover to a level that makes sense on a full cycle exploration and development basis.