Natural Gas: Fundamentally Bearish but Expecting a Seasonal Rally

Includes: CHK, HK, HNUZF, SD, UNG, XOP
by: Papa Roach

Here we are, starting October on a good note weather-wise (at least in Houston). You couldn’t ask for a string of beautiful days like we have had. Last month’s price action indeed avoided the seasonal rally that has come to be expected like clockwork. The story has remained a bearish supply side, HBP drilling tale in shale (Hold By Production, a general lease clause). The Atlantic tropical season is on its downhill slide, and we in fact did see a fairly active season with 14 named systems as of this writing, 7 of which were hurricanes and 5 of those majors. However, the offshore production area was unfazed this year with most activity staying away from the central gulf coast. The precautionary shut-in volumes were negligible. The big story of this summer has been extreme temperatures.

The summer of 2010 will go down in the record books as one of the hottest on record. The graph below depicts the meteorological summer (June-August) and compares quite bullishly to last summer.

click to enlarge images

The temperature regime created a spot market premium the entire summer that rivaled what you would expect to see in high winter heating demand as gas-fired power generation was humming along to meet the high CDD loads (Cooling Degree Day). These temperatures created a level of demand that masked the high level of US supplies and likely saved a few smaller E&P companies from very tough times.

However, the market’s ability to sustain prices that were high enough to keep a healthy drilling pace will likely be the unraveling for some as prices did not do their job of curtailing supply. Most drilling in shale is indeed for HBP purposes; however, there was still a moderate pace of traditional vertical wells that kept the supply side moving higher throughout the period.

Many analysts still fail to fully appreciate the forced drilling behaviors and have fallen flat on their face in predicting large supply declines. Also to note, many people bottom fishing for this decline have mistakenly used the popular EIA storage graph as a determining factor for supply, the problem being that it doesn’t fully portray the demand drivers such as weather extremes. In the case of this summer, many have mistaken a drop in the angle of attack of injections as a decline in supply, when in fact it was driven by extreme temperature demand, which is transitory.

Working Gas in Underground Storage Compared with 5-Year Range

As temperatures have finally abated, the full force of supply is showing up in outsized injections vs. last year and the five-year average, and should continue until we see larger heating loads.

So, where do we go from here? This is quite the conundrum, for me anyway. The fundamental picture remains rather bearish and isn’t likely to change much here anytime soon. However, there are underlying dynamics that argue for a rally here to some degree.

Looking at action, this market continues to find support in the general $3.70/$3.80 area. It appears that everyone short wants the other bears to add new sales when we fall into the range, and we thus fail to find any sizeable new sellers to drive us lower; case in point is the last several sessions. The market is finally experiencing cash discounts in the -.20’s range to nearby futures, which has not been seen since spring, injections are on pace to have a string of 80’s over the next two-to-three weeks rapidly closing in on the year-over-year deficit and gaining on the five-year surplus, and mild overall conditions are expected through most of October. We are in the most bearish of fundamentals seen in many months and fail to trade lower. Call it selling exhaustion as producers seem unwilling to add additional sales at these levels going into an already depressed pricing regime for winter.

With November futures now imminent, we are not trading the current October weather as much as the expected November forecasts, which are expected by some to be more bullish in demand than last November. November 2009 was a rather warm period, especially in the higher demand region for that particular time (the northeast quadrant of the country).

Note that there wasn’t a single state in the lower 48 that experienced below normals for November last year, and 25 states in the much above normal category. This should make the year-over-year comparisons more supportive weather-wise. The full effects of a warm La Nina winter are not expected to take over until we get into the core meteorological winter (December through February). This is also likely supporting prices from further decline at this point.

Another dynamic that is taking hold here, is the prospect of QEII (quantitative easing, our Fed’s "brilliant" strategy to save the world). This has reintroduced a downtrend in the US dollar and created a broader commodity rally. US natural gas is really not affected by dollar valuations. However, many of the funds that invest in the commodity baskets as valuation hedges do not take this into much consideration; they make allocations broadly across the board, snatching up “cheap” looking assets. As the commodity basket continues to appreciate in dollar terms, especially the crude basket, look for some level of unsophisticated buying supply to come into this market.

At this particular time, although I remain bearish on a fundamental basis, I expect that we may see a seasonal rally to some degree. The overall speculative market is net short, and even staunch bears are likely to see that the best way to a lower price market is to rally first, which eliminates prices working to stem supply for now - an even more bearish dynamic for the first quarter of 2011. Those that trade natural gas ETFs and E&P stocks can scale in small here for a short-term play to the upside on these factors. I still expect a very low price to be realized in Q1 if winter indeed verifies to the moderate/strong La Nina winter analogs.

Disclosure: Long and short various futures and options on natural gas.