Moderating Temperatures and Economic Instability: Bearish for Natural Gas Prices

Includes: GAZ
by: Valerie Wood

Typically, analysts use either a fundamental or technical approach to market analysis. Energy Solutions, Inc. uses a combination of both techniques in its evaluation of bullish and bearish natural gas market conditions and its search for natural gas buying opportunities. The following analysis is taken from the August Monthly Edition of Energy Solutions, Inc.'s newsletter, The Advisor.

Fundamental Pricing Analysis

Record heat in July pushed natural gas prices up. However, as temperatures have moderated, the front-month natural gas Nymex price is again trading at around $4 per MMBtu. With the increasingly uncertain economic outlook, there is little data to support a price move higher for natural gas. The only potentially bullish fundamental price driver is the fact that there is around 6,100 megawatts of nuclear power shut-in right now, in comparison to 3,300 megawatts one year ago.

Plus, the tropics are heating up as the months of August, September, and October typically mark the peak of tropical storm activity in the Atlantic. However, natural gas output from the Gulf of Mexico has dropped from around 13.8 Bcf/day in 2001to 5.5 Bcf/day today. While storm-induced supply disruptions may still prompt a speculative short-term price rally, the threat of a long-lasting impact is now much less than it was five to 10 years ago.

A number of factors point to price weakness. Baker Hughes (NYSE:BHI) recently reported that the natural gas drilling rig count rose to 896 for the week ending August 12. This is the highest level since March 2011. In fact, the active natural gas drilling rig count is now 26 rigs higher than where it was in mid-June. In the meantime, natural gas production has also continued to rise, and there is still a backlog of around 3,500 uncompleted wells that can be brought into service very quickly. The normal backlog of uncompleted wells is typically only 1,000 to 1,500.

Plus, as fall approaches, temperatures continue to moderate, which means that natural gas demand from the electric power sector to meet air conditioning needs will decline. As this occurs, storage injections will increase. This, along with slowing economic growth and increased production, means that natural gas supplies will continue to outpace demand.

Technical Pricing Analysis

The ongoing debt issues in the U.S. and Europe have created a great deal of economic uncertainty. The week of August 8 was tumultuous for equity markets, with hundreds of points of losses followed by surprising rallies the next day. This yo-yo trading has led to concerns of a new recession or heightened potential for a double-dip recession as investors flee commodity and equity markets seeking the safe haven of cash.

At a minimum, it appears that economic growth is slowing to a snail’s pace and will continue to lag behind the expectations of most economists. This slowdown is supported by data from sources such as the Institute of Supply Management Purchasing Managers' Index, which recorded a reading of 50.9 percent in July —a decline of 10.5 percent since February 2011. A reading in excess of 50 still indicates expansion. However, if this reading dips below 50, it will indicate a contraction.

A global economic slowdown directly correlates to reduced oil demand. Economic fears have sent crude oil prices tumbling. The front-month crude oil Nymex contract has dropped by more than $10 per barrel since August 1, trading in the mid-$80s on August 12. Long-term price erosion in crude oil prices provides additional support for economic weakness, which doesn’t bode well for natural gas prices.

However, there have been some interesting technical developments for natural gas commodities. Market data shows that total open interest in natural gas futures contracts recently increased to an all-time high as new players entered the market and took on a net-short position.

Speculative investors who take on a net-short position are doing so with the premise that they will make money by buying in the future when prices decline. A short position is in essence a “sell high, buy low” plan. As a result, if speculative players are taking this potential “sell high” position at around $4 per MMBtu, there seems to be little reason to be bullish on natural gas prices, particularly if consumers curtail spending as expected. The big question now is: “What is the ‘buy low’ price point at which these speculators will exit their net-short positions?”

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