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By Lara Crigger

It's that time of year — Every fall we touch base with Christopher Jylkka, principal and manager of Boston Energy Trading, LLC to get his take on natural gas, as we head into the peak demand season of winter.

Having tracked the energy markets for more than 13 years, Jylkka is an expert on the day-to-day tactics and long-term strategies of natural gas players, and what he has to say about the winter of 2010 isn't particularly encouraging for natural gas longs: boatloads of supply, technological advances and an LNG infrastructure ready to pounce on price spikes.

This week, HAI Associate Editor Lara Crigger got the gory details from Jylkka.

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): We've had a comparatively mild hurricane season. How do you see that impacting natural gas prices as we head into the winter?

Christopher Jylkka principal/manager, Boston Energy Trading, LLC (Jylkka): There's always a risk premium built into the front-month contract of NYMEX natural gas for a supply disruption, which typically peaks around the first week of September. I'm not sure how active the season was, but there were definitely some named storms, and maybe not close calls, but some that developed and tracked to the east of the supply area. So you did see that run-up in prices maybe going back a couple of weeks.

But we're well past the typical peak of storms. We could still get one, and that's an upside risk. But every day that goes by, the probability of storm-based supply disruption gets smaller and smaller.

Crigger: Are there other supply disruptions that could still occur?

Jylkka: Yes, but you have to look forward to the winter. About 20 percent of natural gas supply comes from shale production, which is on shore; some of that from east Texas or even in Pennsylvania, which is now producing quite a bit. You have a different dynamic there. You don't have the devastation that a Katrina would bring, or evacuations, but if you get a prolonged cold spell you can get wellhead freezes, which means a supply disruption from severe cold, possibly.

Crigger: I'm glad you brought up shale gas, because that really is becoming a bigger and bigger part of the US natural gas industry. But there's a lot of uncertainty in terms of development, and whether it will overtake or just supplement traditional projects. How do you see this uncertainty?

Jylkka: In the media there has been a lot of focus on the fracking liquid that they use. And what they're getting hold of is the risk of some of this fracturing liquid leaking out in a place like the Marcellus shale [Pennsylvania], where it's sensitive to groundwater and habitat. The state made its own regulations, and there's also some involvement from the EPA, but still the bulk of the shale gas does come from east Texas. The Marcellus shale has been ramping up, but my focus is short term, so it doesn't factor into my analysis. I don't see it as a real risk in the short term.

Crigger: Well, what are the real risks in the short term?

Jylkka: When I say short term, I really mean one to three months out. I see production increasing almost every day. There are a lot of dynamics - words being bandied around by pundits like "the shale revolution" and the "technology shock." There are definitely people on the speaking circuit talking about this, and it's really all true. We're seeing production increase almost every day. The gas market loves to make year-on-year comparisons. They love to look at last year and a five-year average. When it comes to inventories, it's always, "What happened last year, and what happened over the last five years?"

On top of this new "Shale Revolution," we've had major increases in gas infrastructure. For instance, this pipeline called REX [Rockies Express], made by Kinder Morgan (NYSE:KMI), which pretty much bridged the traditional supply area of the Rockies all the way to eastern Ohio. There are other companies building laterals which attach to that. This is really just happening in the last year or so. There've been increases in storage — the overall storage capacity of natural gas — which includes salt caverns and such; that's increased quite a bit.

And then the EIA is predicting a lot lower power demand this year on top of the supply situation. And the EIA is not always right, but I've seen a few independent analysts which agree with them. Basically we're getting technology gains in appliances, and even large commercial gas turbines are getting more efficient. Houses are getting more efficient. So projected power demand wouldn't seem to recover to '08 levels for a whole.

Crigger: More storage. More capacity. Less demand. That doesn't spell higher natural gas prices.

Jylkka: I'll add another comment too: This will mitigate spikes. We're seeing lower prices — we haven't seen prices at this level for a while — and a lot less volatility, reflected in the implied volatility in the options market. And even in the daily and monthly price movements themselves.

One thing that people fail to consider is that a few years back, people thought we'd run out of reserves for gas, and there was a big build-out for LNG. The aftereffect of that was that they had to build liquefaction capacity, where they take the gas, liquefy it, ship it out and then re-gassify it. So this infrastructure was built and never used. There's a tremendous amount of idle infrastructure. If prices do get higher, you'll see LNG come to the United States if we get a prolonged spike. In general terms, that acts as a kind of price cap.

Crigger: LNG tends to be bigger over in Europe, right?

Jylkka: And in Asia, too. This dovetails into shale gas. We're seeing shipments of LNG leave Texas for Asia this year. I think that's a new thing.

I also look a lot at the weather. You look at the climate drivers. It's looking like this winter will be a strengthening La Niña winter. That means a warmer-than-normal winter overall in the East and the South, and the East of course is a big demand region. That's sort of a sweeping gesture: We don't know if that will really happen or not, but that's what the long-term drivers are showing right now. They do show potentially colder November and December, and a warmer January.

Crigger: So you have a bearish outlook for the winter?

Jylkka: I do. I see a couple of things in the short term, though. There is an implied floor on the price of gas, and that's coal switching. That's not saying that a coal unit can switch to burning gas, but it does say that a large company like Southern Co. (NYSE:SO) or a big major utility with a portfolio of plants does have enough flexibility that they can stop burning coal. We are at those levels now. We're starting to see some switching. That's a possible bullish driver, but I don't see it as a big driver.

The other upside could be a super cold November or December in the East, but I think overall the picture is downside.

Crigger: Well, if I did think now was the time to buy, should investors be looking to the futures, with something like UNG or UNL? Or to equities, with something like FCG?

Jylkka: I think a blend is the way to go. Equities aren't really my space, as I focus on the commodities themselves, but there are some pretty exciting mid-level players who are securing very valuable land. The leasehold provisions now ... people can secure a lease to drill on land, but the provision is that they have to produce on the land within a certain period of time. So you could see some non-economic production in the short term, but the forward curve of natural gas is usually higher, so they're just deferring some income into the future. If you look at the mid-level ENP players in the natural gas space — the people who are active in Marcellus shale and other major shale areas — I think it's pertinent to have some exposure to that. But I also think it's good to have some exposure to the front month, which is what I focus on.

Crigger: So you'd prefer UNG over UNL then? Since UNG is all front month?

Jylkka: For me personally, since I'm focused on the short term, I focus on the front month. I'm not your average investor. I really think a blend is good. I think some exposure to the front month is good, but I do like the equity side for the longer term. And you're seeing a lot more generation being built, more gas, less coal. And in places where you have a large penetration of wind — west Texas, the Pacific Northwest - it's growing so rapidly that to back up the wind turbines, they will have to build peaking gas turbines, believe it or not, to manage the intermittent nature of wind. Newer natural gas units can handle ramping up and down, offsetting production from the wind.

Crigger: Thanks for talking with us today.

Disclosure: No positions

Source: Christopher Jylkka: Bearish Winter for Natural Gas