What Natural Gas Prices Say about the Domestic Economy

While trying to avoid U.S. government reports as much as possible due to their lack of accuracy and "sunny side up" disposition, there are some much better places to look for a reality check. On the consumer side of the equation, I like to review the results of Walmart (WMT) and Target (TGT), and on the industrial side, we can use natural gas.

Unlike almost every other commodity on Earth which has been soaring, natural gas has remained in the tank. Since most commodities are relatively easy to move across the globe (or to be put in storage, especially cheap to do with nearly free money handed out by central banks), their prices have been increasing... along with the now infamous weak dollar play. However, the difficulty in moving natural gas long distances means that it's a great domestic marker; hence its performance is even more damning considering the weak dollar. To put it in perspective, natural gas was peaking near $14 in first half 2008, and now it sits back in the $4s. Much as electricy usage gives us a far better idea of what is happening inside the country of China, natural gas gives us a reality check from the green shoot crowd domestically.

• Natural gas prices have dropped by more than 12 percent in the past month as the country continues to sip at its energy reserves and a balmy November allowed homeowners to leave the heat off.
• The recession has kept natural gas demand low most of the year. With manufacturers shuttering factories and closing offices, the country is using less electricity and power plants are burning less natural gas.
• Analyst Stephen Schork noted that with industrial production still weak, home heating would be the primary source of natural gas demand for the rest of the year. "What does that say about the current recovery, or lack thereof?" Schork said in a research note. (indeed)

During the summer, we spoke about the eventual "filling" of all U.S. natural gas storage that would be coming sooner or later... it seems right around the corner.

• The U.S. has added more natural gas into storage every week since March 27, and there is now more natural gas tucked away in the U.S. than at any point in history.
• Storage houses are crammed beyond their listed capacity in the West on the Gulf of Mexico, and they're nearing capacity elsewhere, according to data from the Department of Energy.

That said, we're still producing like gangbusters! American executive compensation schemes ("heads we win, tails we still win") call for pushing more and more production out into the market, rather than acting rationally in a textbook "supply vs.demand" dynamic. Why? Because shareholders reward those companies which can show "growth" of natural gas production with higher prices, and that is how a CEO is judged. [Aug 6, 2009: Why are Natural Gas Producers Expanding Production So Aggressively?] Cut back production when natural gas in storage is at its highest levels in U.S. history? Nah, it might cut into my bonus - supply and demand and the business cycle is so old school.

For all the talk about how the 'free market' works, one must see the misallocation of resources when individual compensation rewards are not based on rational behavior, but are simply goosing figures that investors wish for ... in this sector "growth at any cost" is the thing. No different than what you said about banks about 36 months ago - growth at any cost - who cares where it comes from. There is no "bad growth" in America. From August:

Even as they lament a gas glut, the companies have been reluctant to let revenue and profits fall further in the short term by being the first to curtail output.

“I think they might be cutting off their nose to spite their face here,” said Jim Byrne, an analyst at BMO Capital Markets in Calgary who rates Anadarko (APC), Devon (DVN) and XTO (XTO) at market perform. “Everybody’s kind of worrying about themselves, and obviously that’s going to happen, but it doesn’t really bode well in our view, certainly for gas prices.”

The companies are pumping more gas than ever in the face of a demand slump and a supply surfeit that caused prices to plunge 72 percent from their 2008 high. U.S. gas supplies are 19 percent above their five-year average.

Investors are rewarding companies for production gains.

There’s a pretty clear correlation between production growth and stock performance,” Hanold said. “These exploration and production companies want to take advantage of that.”

Comments

[very rare]

Now we have 2 USA natural resources (natural gas and coal) that we don't use. But don't stop buying all that oil that is still priced high from over there. The people are screwed again!

2009 Nov 23 06:29 AM

[somecatchyphrase]

The natural gas resource could be America's salvation.

We need to get busy on this ASAP.

2009 Nov 23 07:14 AM

[john s. gordon]

it seems that NG exploration in the alberta foothills has also languished. a year ago most of the production was going over to fort mcmurray to fuel the oil sands production.
> jack

2009 Nov 23 08:44 AM

[Ferdinand E. Banks]

"Investors are rewarding companies for production gains". Sounds nutty, but I recall when the CEO of one of the big oil companies said that in the future his firm would pay more attention to profits than production. I also recall being sarcastic with students who suggested that some producers maximize production, but maybe they knew more than I did at the time.

2009 Nov 23 09:35 AM

[Rick Krementz]

For those of you who missed Econ 101 in college, here is a little refresher. Natural gas is a commodity, so there is no way to increase your margin over the market price. Natural gas extraction and delivery is highly capital intensive, which means high fixed costs, such as interest and equipment maintenance. Since the gas market is relatively free and competitive, there is no single monopolistic producer than can set prices.

Any CEO who did not sleep through Econ 101 knows to maximize profit (e.g., his/her bonus and stock price) knows he has to generally produce as much as he can so long as his marginal cost is below his marginal selling price.

There is no benefit for a CEO to reduce his company's production, although he would love it if all the other CEOs reduce production. When all the storage is full and production exceeds current demand, then he will reduce production because prices will crater.

His only other option is to try to control prices with a cartel or oligopoly, which is illegal.

This has nothing to do with irrational CEOs or investors. This is basic economics.

2009 Nov 23 11:35 AM

[HowardI]

We have an unbelievable wealth of natural resources. Our river system, our rich agricultural land, a dynamic mobil population, enormous fossil fuel resources, one of which, natural gas, is a cleaner source than any other fossil fuel.All we lack is purposeful aggressive leadership. Although Boone Pickens is trying.

2009 Nov 23 12:28 PM

[igggy]

I wish the government would offer an incentive for people to convert from heating oil to natural gas. Seems like that should be a no brainer.

2009 Nov 23 12:48 PM

[Mark Anthony]

TraderMark:

I disagree with most of what you said. Maybe you should study the natural gas supply/demand number a bit closer:
Consumption:
tonto.eia.doe.gov/dnav...
Production:
tonto.eia.doe.gov/dnav...
Importation:
tonto.eia.doe.gov/dnav...

There is no clear indication that the consumption has dropped significantly due to economy. The numbers do not show that. The bigger effect is we have had an unusually warm 2008/2009 winter, and an exceptionally uneventful summer (no hurricane). There was a shale gas drilling boom in 2007/2008 which results in some what higher production, which lasts till this day. But the bottom line is consumption hasn't really dropped.

As for the storage, look at the chart here:
www.eia.doe.gov/oil_ga...

As you see, the storage deviation from average level was mostly built up during the warm 2008/2009 winter. There was no further build up of the deviation afterwards, if you look at the slope of the curve, in comparison with past years.

Putting the storage number into context, there is noe 3833 BCF in the storage, at average consumption of 62 BCF per day, the storage is good for 62 days. Current storage compare with same time last year, is only higher by 347 BCF, worth 5.6 days consumption, or 1.53% of one year.

So in one years time, despite of significantly higher production, and despite of a very warm 2008/2009 winter and an hurricane-less summer, the total supply exceeded total demand for only 1.5% for the past one year. Is 1.5% a lot, consider the exceptional weather condition that contributed to it?

On the other hands, the shale gas wells will not last. These wells deplete at an alarming 60% to 75% annual depletion rate once they start to produce. Unless producers keep drilling like crazy, the production will not last and will not be able to meet demand.

I am absolutely certain natural gas is extremely bullish, producers know that. But I am deeply reserved on whether UNG is the right vehicle to profit from a natural gas bull. Read here on why:
seekingalpha.com/autho...

2009 Nov 23 01:29 PM

[Lesismore46]

You are correct on some points but not on others:
marginal cost should equal marginal price, but quantity demanded must equal quantity supplied for there to be equilibrium. So as QD drops or fails to increase, QS must also drop, not increase! Prices have already plummeted because of low QD. Yet the producers have failed to reduce QS, so we have a surplus. The only way to relieve a surplus is for prices to remain low, QS to decrease, and as the economy recovers, QD will increase. The producers are definitely ignoring the economics of the market by continuing the surplus. Prices will not recover until the surplus is reduced. This is ECON 103

On Nov 23 11:35 AM ricardoRI wrote:

> For those of you who missed Econ 101 in college, here is a little
> refresher. Natural gas is a commodity, so there is no way to increase
> your margin over the market price. Natural gas extraction and delivery
> is highly capital intensive, which means high fixed costs, such as
> interest and equipment maintenance. Since the gas market is relatively
> free and competitive, there is no single monopolistic producer than
> can set prices.
>
> Any CEO who did not sleep through Econ 101 knows to maximize profit
> (e.g., his/her bonus and stock price) knows he has to generally produce
> as much as he can so long as his marginal cost is below his marginal
> selling price.
>
> There is no benefit for a CEO to reduce his company's production,
> although he would love it if all the other CEOs reduce production.
> When all the storage is full and production exceeds current demand,
> then he will reduce production because prices will crater.
>
> His only other option is to try to control prices with a cartel or
> oligopoly, which is illegal.
>
> This has nothing to do with irrational CEOs or investors. This is
> basic economics.

2009 Nov 23 01:54 PM

[TraderMark]

So we are reaching the stage of full production.

Now you believe CEO's will curtail production?

Let's check back in 3 months.


On Nov 23 11:35 AM ricardoRI wrote:

> For those of you who missed Econ 101 in college, here is a little
> refresher. Natural gas is a commodity, so there is no way to increase
> your margin over the market price. Natural gas extraction and delivery
> is highly capital intensive, which means high fixed costs, such as
> interest and equipment maintenance. Since the gas market is relatively
> free and competitive, there is no single monopolistic producer than
> can set prices.
>
> Any CEO who did not sleep through Econ 101 knows to maximize profit
> (e.g., his/her bonus and stock price) knows he has to generally produce
> as much as he can so long as his marginal cost is below his marginal
> selling price.
>
> There is no benefit for a CEO to reduce his company's production,
> although he would love it if all the other CEOs reduce production.
> When all the storage is full and production exceeds current demand,
> then he will reduce production because prices will crater.
>
> His only other option is to try to control prices with a cartel or
> oligopoly, which is illegal.
>
> This has nothing to do with irrational CEOs or investors. This is
> basic economics.

2009 Nov 23 04:26 PM

[Rick Krementz]

Thank you Lessismore for your comments. (I was formerly ricardoRI)

I think you are mixing QD (quantity supplied) and quantity consumed (QC). QC has declined because of the recession. However, QD remained stronger because investors (speculators) were willing to buy and store gas as long as there was storage available. Now that there is very little storage available, the investor demand must diminish until either more storage is created or demand picks up (and reduces stored gas inventories). Since building significant gas storage is not an instant process (months to years for construction), I think we will see cuts in production soon.

Longer term, I think we will see constrained domestic gas supplies and higher prices. The shale well production is unlikely to be sustainable because of very fast depletion and more drilling may well be curtailed by environmental issues relating to fracking. Natural gas will be used for more electricity production since it is the easiest way to stabilize the grid with intermittent wind and solar generators. Gas may also be used for vehicles which could be a huge demand.

I wouldn't be shocked if gas prices reach record highs in a year or so.

Disclosures: long OGZPY, XOM, BP, LUKOY, PBR and a portfolio of alternative energy equities

On Nov 23 01:54 PM Lesismore46 wrote:

> You are correct on some points but not on others:
> marginal cost should equal marginal price, but quantity demanded
> must equal quantity supplied for there to be equilibrium. So as QD
> drops or fails to increase, QS must also drop, not increase! Prices
> have already plummeted because of low QD. Yet the producers have
> failed to reduce QS, so we have a surplus. The only way to relieve
> a surplus is for prices to remain low, QS to decrease, and as the
> economy recovers, QD will increase. The producers are definitely
> ignoring the economics of the market by continuing the surplus. Prices
> will not recover until the surplus is reduced. This is ECON 103<br/>
>
> On Nov 23 11:35 AM ricardoRI wrote:

2009 Nov 24 01:03 PM

[NutritionFacts]

Mark Anthony, excellent riposte.

2009 Nov 26 11:37 AM