Natural Gas Recovery is 'Relative' - Interview with Boston Energy's Chris Jylkka

| About: The United (UNG)

By Lara Crigger

The last time we spoke to Christopher Jylkka, principal and manager of Boston Energy LLC, he forecasted tough times for natural gas throughout the winter. Lo and behold, natural gas prices stayed low, pressed down by persistent oversupply and mild temperatures in major gas-consuming areas.

That's why we thought we'd check in again with Jylkka to get his take on the fundamentals for natural gas right now. Jylkka, who has over 12 years' experience in the energy industry, is an expert in the trends and fundamentals shaping the natural gas markets. In addition to his role at Boston Energy, he serves as regional director of energy market intelligence firm EnvaPower.

So given President Obama's recent offshore drilling announcement, a revamp of the monthly EIA-914 production report, and warmer than normal temperatures across the U.S., where does Jylkka see natural gas heading next?

Crigger: Last September, you correctly predicted we'd see rough times for natural gas through the winter. Is there any chance of a recovery for natural gas anytime soon?

Jylkka: I think recovery is kind of relative. Now, when I speak about price, I always refer to the front-month futures contract; so if you look at 2008 levels, we got up to a peak of $13.50. I don't think we're going to see those levels again soon. That was pretty high.

But recovery is relative. So if you look at the price going back last year, the average for the front-month was about $4.20. Now they're forecasting summer prices around $4.44.

Crigger: So we're a little bit ahead of where we were last year, but not by much.

Jylkka: Yes. But gas is so volatile. We were trading as low as $3.82 just last Thursday! So on any threat of hurricane, or if we had a heat wave from Texas or California-two of the major demand centers-you could easily hit $5 for a period of time. That would be a 30 percent move from the low. So it's all relative to what your time frame is. The volatility of gas makes it a different beast.

Crigger: How do the weather forecasts look for the summer? Will temperatures be helping support a higher natural gas price in the next few months?

Jylkka: We look at big climate drivers such as El Nino. The strength of El Nino is fluctuating; they've characterized it from a strong El Nino to a moderate one to a weak one, back up to moderate. But it's forecasted to decline into a La Nina, and that bodes well for a warm summer, particularly in Texas. Texas is a huge consumer of natural gas.

So while I don't think you're going to see a big rally, I do think you will see some volatility with a warm summer. And if you couple the hurricane threat with that, you could easily see $5.

Crigger: How will the president's new proposal to expand offshore drilling in the Gulf and Atlantic Coast impact the supply situation in natural gas and, by extension, prices?

Jylkka: Well, I focus mainly in the short term. So there's a portion of that land for which they may find leases within a year or two, but it's a very small portion. I think the majority of the leasing's going to be done in 2015. So by the time they get the rigs out there and start producing, I'd say it would be 2017-2020, to be realistic. It's going to take awhile. In the meantime, the Department of the Interior's probably going to spend years doing geological analysis, and private companies are going to be out there as well trying to figure which rigs are better for gas, or oil, or both. So at this point, we really don't know.

So even though that time frame seems long, there are a lot of technologies that are in development. Even as we speak, offshore drilling is getting more and more efficient. So this announcement buys companies some time to develop new deep-water drilling techniques, which would be very important for future supply. But it's just too early to tell.

Crigger: But we're seeing a psychological effect from this announcement, I think.

Jylkka: I think President Obama did it to win support for the upcoming climate bill, for carbon dioxide legislation. This is just my opinion, but I think he did it to win support from conservatives; I think that's the main reason behind it.

I think it was a political move, and not a bad one, either. Because if you think about it, the price of carbon has to be known. All these coal plants that are being shelved, the people to build them; all these people making huge capital decisions whether to put a scrubber on their stack-no one really knows what the price of carbon is in the U.S., because there really isn't one, at least not for the entire U.S. So I think that's really important. I think what he's doing is great; to get some climate legislation in there as soon as possible is good for everyone.

Crigger: Last week, the EIA announced that it's changing its methodology on how it calculates monthly U.S. natural gas production numbers. What's your opinion on this? Will it make a huge difference in the market?

Jylkka: Potentially, yes. All this hubbub is about the EIA-914 monthly production report, and a lot of people had suspected that the numbers were off for awhile. So they're going to change the methodology, which will debut on April 29. When they do that, they're going to go back and revise the past six months, back to November 2009. Later in the fall, they're going to revise the rest of 2009.

If you look at the new paradigm of natural gas supply, it's coming from these unconventional sources like shale plays, such as Marcellus Shale or Haynesville Shale. They're really ramping up on that since May or June last year. So after they revise these numbers, you could see in some states a rather large difference.

Currently, believe it or not, the EIA is using data that's two-seven years old. Under the new methodology, they'll use data which is six-18 months old-which is still old, but it's not as old as seven years! They also calibrated the models annually before, and now they'll do it monthly.

They pretty much put this process in place when it was a different world for natural gas. It's just gotten out of control.

Crigger: So a lot of traders knew the numbers were off? How does that affect your trading?

Jylkka: I think it's tough, because so many people rely on the EIA, not just for gas but oil, too.

Crigger: And they recently announced that their calculations for the weekly inventory reports for oil were suspect, too.

Jylkka: Right. But compared to other commodities like orange juice or cocoa, there's actually a lot of really good public data about natural gas. There is still a lot of data, even if some of it's bad.

And the other thing is: There's no acceptable alternative. It's just the EIA. The Wall Street Journal broke this story over the weekend, and I think that was probably a good thing, instead of breaking it right before the supply report. So I think the market priced that in, initially. And now it looks like the market's gone back to where it was. It'll be interesting in these weeks leading up to April 29.

Crigger: So is there still money to be made in natural gas, with the volatility and oversupply situation? It all looks a little depressing for an investor.

Jylkka: It does, but a trader looks at volatility, and not price. So high volatility doesn't necessarily mean high prices, and low volatility doesn't necessarily mean low price. Sometimes when the price is low, you have higher volatility. So I think the monthly average for historic volatility usually every year gets up to 30 or 40 percent. But it's not uncommon in the last 10 years to see a 100 percent move in natural gas. When the economy kicks back in, you could start to see a return to those volatility levels.

So there is money to be made. But most traditional investors are long-only; as humans, we're programmed to buy things, not sell them. But you have to look at things both ways; I've made most of my money on the short side. I think there is opportunity still to play the volatility.

Crigger: It's interesting you bring up the long-only side, because we've seen investors getting creamed by long-only futures-based natural gas ETFs, like the U.S. Natural Gas ETF (NYSE Arca: UNG). Are these vehicles a wise choice for investors, or should they consider other options for natural gas exposure?

Jylkka: I think the long-only approach to UNG has been self-explanatory. For six months, it hasn't been a very good idea, unless you have a very long time horizon and can sit through that volatility.

I've always traded futures, and I'm a CTA, and I think managed futures for the right person are the right way to go. Of course, I'm talking my book here, but I think the right manager is a pretty good route to go.

If you're not going to do that, I think you have to do hedged plays-if you're a good stock picker, and know how to read balance sheets and 10-Ks, you could check out some of these E&P companies. You could go long the company and hedge it with some options, or you could do a long-short combination with a driller you like, versus a driller you don't like. But myself, I'm purely a directional guy, and focus just on the commodities themselves.