Where Can Winter Natural Gas Prices Go?

by: Five Thousand Over Libor

Quite a week last week. We started the Gas Winter (Nov 1 – Mar 31) with the 10th largest non-Thursday decline from high-trade to close in 10 years – and when making room for the fact that last Monday’s high was 2.7% above Friday’s high, the largest DoD increase in highs among the top 10 high-to-close declines - you’ve got one of the ugliest daily candles ever produced in NG futures.

Natural gas often trades in its own world, largely insulated from the insanities of the broader market, be it Crude, Gold, the US Dollar, SPX, Apple (NASDAQ:AAPL), etc. The reason's largely simple: it’s a regional commodity with limited substitutional capabilities where the vast majority of end users spend dollar-incomes to consume dollar-gas. This is one of the primary reasons why last week, when money managers across the world were looking at the spectrum of YTD returns across global asset classes, right next to Haitian Real Estate they saw NG Futures at -29% in the constant prompt contract, -39% for the DEC 2010 outright. With equity indicies on pre-Lehman levels, Oil screaming on 25-month highs, Gold at your mother’s kidney, and the 5-yr US Treasury making record-low yields, what’s a manager to do?

Buy NG.

Given the race-call trumpet from Ben last Wednesday and news last week of large end-of-year commodity-index rebalancing, this last-of-the-global-dogs (still) was certainly blinking like a launch command from NORAD for many. And, generally speaking, the less you happen to know about the natural gas, the brighter the blink of the blinking red light.

So, last Monday’s candidly breath-taking, no-bounce beat down morphed into a doji for the weekly chart. What a week.

Prices are low: if DEC were to expire here, it would be the lowest DEC expiry in 8 years, all the way to $4.140, the DEC 2002 roll. DEC 2010 settled 85 cents back from DEC 2009 this date last year, and Calendar 2011 trades $1.20 behind where Calendar 2010 was trading one year ago. So, the onus is on the bears to keep things looking gloomy. The minute we walk into a Sunday evening where the 11-15 day forecast is showing all the tell-tale signs of an eastern-US cold wave, given where the price is, we will most likely rally through last Monday’s high ($4.19 DEC). This weather burden, on top of the exogenous interest from money managers who aren’t in a business of watching the drivers of natural gas all day, assuming no major producing-region storage constraints, makes it hard to see us taking out the $3.50 low in the DEC contract before it rolls.

But the higher prices go, the worse prices will likely get. And given the composition of the final buyer in this market, a combination of the fundamentalist who got too short too early and the increasingly confident fund manager who is *finally* ready to show this NG who’s boss (weighting favoring the latter), price could achieve a fantastically contra-fundamental level, say the upper 4s to perhaps $5, if we can get this into a prompt JAN contract. But make no mistake about it, this market is dramatically oversupplied (which I have discussed at length all summer), and nothing paints that picture like the 481 Bcf built over the past 6 weeks (Sep 18 – Oct 29), a record since the initiation of weekly NG storage reports in 1994. This is why YoY storage went from the -215 Bcf deficit, which served as many declining-supply barkers’ summer drum, on Sep 2, to a +37 Bcf surplus as of Oct 29.

Total US gas rigs have not materially declined (per Baker Hughes, only 37 rigs off the high, 12 of them coming in Friday’s report, with YoY rigs still at +221, in the upper 10% of all YoY readings since 1988) and much more importantly, the continuing surge in horizontal rigs, which Friday made another all-time high to 947 rigs, are now only 121 rigs off the previous all-time high of vertical rigs in Aug 2006. Get your mind wrapped around that for a moment.

Additionally, two large to-market-transport projects are becoming market realities this winter, Fayetteville Express Pipeline and TIGER Pipeline. Both are to-market pipes connecting Fayetteville and Haynesville properties, respectively, to multitudes of long-haul interstate pipes including ANR, TGP, Trunkline, TGT, and Tetco. FEP is already scheduling test flows and will go commercial in the next several weeks and TIGER is slated for a Q1 in-service date. Both are 42-inch 2.0 Bcf/day behemoths. Given these rig and pipe facts, it’s tough to see meaningful declines in supply this winter. It’s actually difficult not to foresee incremental production gains, which is why Bentek is reporting new estimates of record levels of daily production this week.

So, a higher price is not what this market needs to balance. We’re going into winter on record storage levels along with estimated record production. Given the best guesses on winter weather, largely predicated upon the La Nina ENSO condition, it looks difficult for us to get anywhere near the 2.13 Tcf draw we posted last winter (2.1 of which came in the 90 days from Dec 1 to Feb 28), let alone the fact that were going into winter with US total supplies (production, Canadian imports, and LNG) averaging +4.0 Bcf/day YoY on a 60-day average (per Bentek). This means, all else equal, we would need 4 Bcf/day less from storage, or 28 Bcf/week, than we would compared to last year. Said another way: we don’t start drawing on storage until 4 Bcf of additional demand, every day, versus last year. Assuming this long-term average moves down to 3 Bcf/day (conservative given the rig and pipe discussion above and the demand-adjusted (e.g. LNG storage) strongly flat total-supply curve last winter), that’s 450 Bcf of storage we won’t need, over the 151 days of Gas Winter, compared to last year. This is before any consideration for what demand will be. In other words, if current balances maintain and even tighten moderately, we would need significantly colder weather this year to garner the 2.13 Tcf draw than what it took last year.

The 5-yr average winter draw from US Storage is 1.9 Tcf. Assuming normal winter weather for the US as a whole, the back-of-envelope storage math for end-of-winter stocks works something like this:

The previous maximum all-time storage level at 3/31 is 1,695 Bcf in 2006 and nearly matched in both this and last year at 1,660 Bcf. Clearly, this math blows that record away and is frankly a level that the gas market will not tolerate and will use prices to avoid. This projected level would allow room for roughly 1,725 Bcf to be built over Summer 2011, assuming we see another 100 Bcf increase in total-storage capacities from this year’s 4,049 Bcf EIA estimate. 1,725 Bcf is well below the 5 yr average Apr 1-Oct 31 summer build of 2,036 Bcf and this year’s build of 2,170 Bcf. We would have to shed 1.4 and 2.1 Bcf/day, against the 5-yr average and this summer’s build, respectively, April 1 – Oct 31, 2011, just to get trajectories inside capacity.

The math is admittedly simple and is not free from the requirement of assumptions, but don't let that discourage you from understanding its influences upon the longevity of a potential early-winter price rally in natural gas.

Disclosure: No positions in stocks tagged.