Speculation, Supply and Rig-Switching in Natural Gas

 |  About: The United States Natural Gas ETF, LP (UNG)
by: Matt Smith

In recent weeks I've received a number of questions about natural gas, so I wanted to take this hotchpotch of queries and address three of them in a post. So here it goes..

Question 1: Do you think the Dodd-Frank Act of 2010 has contributed to the stalled speculation of NYMEX Natural Gas futures contracts?

I don’t believe there is stalled speculation in natural gas; the chart below affirms this. Short positions held by non-commercials (i.e., speculators such as hedge funds) are climbing again toward the realm of previous record highs. As an aside, a further hat-tip to the bears is that short positions held by producers (= commercials) have jumped to a three year high in the last week. It is key to remember that a sideways market does not mean there is less speculation; there is still volatility in the market after all. Just because we are not seeing huge price swings or sustained movement in one direction, doesn’t mean there is not speculation at play:

Click to enlarge

NG Natural Gas Non-commercial Short Positions (combined)

(Click charts to expand)

Question 2: Why do you think there continues to be so much gas supply pouring into the market at these low prices? It seems to me that there should have been a price response by now…but it has not seemed to happen. Are these harvesting companies just happy to make whatever they can?

In no particular order of importance, here are some reasons why production continues be near record levels:

  • Horizontal rigs (of which we are seeing record levels, see below) can cover more area than conventional rigs, making the whole process more efficient / cost-effective as the output per rig is higher
  • Producers are locked into long-term contracts (and likely at higher prices)
  • Producers are loss-leading (it is more cost-effective for them to continue at a loss than shut down production and re-start when prices move higher)
  • Producers have to drill due to leasing permit requirements
  • Production of associated natural gas (a by-product of oil production) is rising

Horizontal Gas Rig Count

Question 3: It seems that everyone has been focused on celebrating the shift in natural gas to hydraulic fracturing in shale formations….but it seems that natural gas rigs / companies have been tapping into to more profitable oil. Is there really even a sizeable shift in the industry that would be sustained despite the volatility in oil prices? If so should we expect to see the change shift the current bearish fundamentals to a more bullish outlook?

It is logical that companies would be trying to shift away from natural gas drilling with prices so low, especially with crude oil looking to enter triple-digitdom. However, just as you cannot change an oil rig to a gas rig simply by flipping a switch, there is more at play here than meets the eye. Comparatively higher costs involved in drilling for oil is dissuading some interest (although profit for Baker Hughes has just quadrupled on demand for drilling), while rising costs will continue according to Moody’s Investors Services ‘as natural gas producers will have to keep working their plays amid unfavorable economic conditions’ (a point highlighted above in question 2). So although crude prices are unlikely to become much less attractive, natural gas production levels will maintain their resilience. Due to increased efficiencies (another point highlighted in the previous question), rigs will have to fall considerably to materially impact production. So while only a minor fall in production is forecast for 2011(0.3% in 2011 according to the EIA) it is unlikely we will see a more bullish outlook for natural gas fundamentals - at least not in 2011.

I hope these responses have been useful - thanks to those for sending in questions, keep 'em coming.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.