A Word Of Caution For Natural Gas Bulls

| About: The United (UNG)


2012 vs. 2011 natural gas electric power burn rates were 4.11 Bcf/d higher. This equates to 1,500 Bcf and helped work off elevated inventories driven by the warm 2011/2012 winter.

2015 natural gas electric power burn averaged 26.46 Bcf/d. The EIA has forecasted 2016 natural gas power burn at 27.5 Bcf/d. A hot summer isn't enough to re-balance bloated inventories.

Electricity demand is anemic and higher natural gas prices will cause electric power burn switching back to coal, thus weakening the bulls' myopic thesis.

$2.60 mm/Btu spot July natural gas feels purely like a short squeeze given the 2,973 Bcf of inventory this early in the injection season.

After today's EIA natural gas (NYSEARCA:UNG) inventory report, through May 2016, inventories are now close to 3 Tcf. Today's big move in natural gas feels more like a short squeeze than driven by fundamentals. It is too soon to declare the bottom is in and we are off to the race as this is a very complex topic. I made this naïve mistake in September 2015, when I wrote that natural gas was poised to move dramatically higher. I was proven woefully wrong. I would argue that it is a fool's errand, even for a hedge fund analyst/ trader that exclusively covers or trades natural gas, to think they can have their finger on the pulse of this diabolical commodity.

Using empirical data from the EIA, I think the 2011 vs. 2012 natural gas power burn comparisons are illustrative and relevant to the 2015 vs. 2016 power burn debate. Perhaps, Goldman Sachs, or some other colorful characters have loaded up on cheap July contracts, after they helped tank the June 2016 contract from $2.15 mm/Btu to $1.92 mm/Btu during the last days of May. Given that the Masters of the Universe are now long, oh how quickly they appear to have changed the narrative to higher power burns. This has helped to create this current short squeeze. These theories are hard to prove, so instead, I will focus on the fundamentals.

As I have learned, natural gas is really a winter commodity. We didn't have much of a winter this year, so the inventory glut didn't magically get worked off. So from my perspective, it is hard to imagine natural gas prices having a big leg up in 2016 before we face the prospect of another winter. In my view, at this point, given the elevated inventories, only material evidence of meaningful and prolonged supply cuts will save natural gas from approaching near full storage capacity leading into November 2016.

Given this new narrative, let's look at historical power burn trends for perspective. Some natural gas bulls (including Forbes' Art Berman) point to the 2011 vs. 2012 time frame and argue that natural gas prices in 2016 will repeat 2012's price recovery. Unfortunately, when I looked at the data, the electric power burn in 2012 averaged 4.11 Bcf per day more than in 2011. This equates to 1,500 Bcf (4.11 Bcf x 365 days) and is the major demand reason why natural gas inventories rebalanced in 2012.

Click to enlarge

This year, the natural gas bulls don't have the luxury of major pent up power burn demand driven by the record low natural gas prices. Natural gas switching at electric utilities took place throughout 2015 driven by MATS implementation, low prices in the second half of 2015, and the secular shift since 2012 towards building new natural gas capacity. So the baseline natural gas power burn is at a much higher watermark. Moreover, if we look at the full year 2015 data, the electric power burn averaged 26.46 Bcf/d.

With four months of actual data in the books for 2016, (compliments of the EIA's May STEO report), the EIA is forecasting full year 2016 natural gas electric power burn at 27.53 Bcf/d. Let's say they are wrong and underestimated. Perhaps other analysts are right about this magical La Nina cycle, which could create actual demand to average 2 Bcf higher than 2015 or 28.5 Bcf/d.

Unfortunately, even under this bullish scenario, 2 Bcf/d x 30 days x 6 months = 360 Bcf. 360 Bcf will help inventories, but it isn't enough incremental power burn to meaningfully dent natural gas inventories.

Click to enlarge

Here are three major inherent headwinds that may prevent natural gas from spiking and maintaining a $3 mm/Btu spot price before December in 2016.

1) After today's short squeeze, spot natural gas prices are now $2.60 mm/Btu, at the margin, more utilities will switch back marginal power burn to coal. Utilities are sitting on massive coal stockpiles and still have 2016 committed coal tons, compliments of legacy contracts. If front month natural gas hits $2.75 mm/Btu, then coal fired plants that burn Powder River Basin coal fire back up.

Some of these coal plants were idled during the winter (just see Cloud Peak's (NYSE:CLD) Q1 2016 conference call). This dynamic keeps a lid on how high the natural gas power burn can get in a rising natural gas price environment. Moreover, the forward natural gas curve is well north of $3 mm/Btu during the winter months, so I expect utilities to already be switching back to coal now.

The natural gas futures curve from the CME Group (NASDAQ:CME).

Click to enlarge

2) Another issue is that oil is now back above $50 and associated gas can increase as shale player can make money in many U.S. oil basins. Many tier 2 producers took advantage of this oil recovery and issued stock in order to shore up their balance sheets. I am not sure we will see the dramatic U.S. shale oil production declines fear in February 2016.

Moreover, the gassy natural gas stocks are trading at expensive valuations based on their production growth profile and their very low-cost structure. The natural gas market is highly fragmented, so companies are heavily incentivized to grow production, which delays inventory re-balancing.

3) Finally, electricity demand is quite anemic. Enclosed below is EIA data for electricity generation. In 2015, it declined by 0.1%.

Concluding thoughts: In my view, it is all about natural gas supply cuts. Warmer weather, La Nina, and electric power burn make for fun reading. Unfortunately, even an incremental YoY 2 Bcf/d higher power burn over the next six months isn't enough to dramatically knock down natural gas inventories. And we know the weather is fickle. Today's high in Boston was close to 70 and it is expected to be cool for the next week. Betting on the weather is gambling.

If I had the bandwidth and I don't, I would focus future pieces on hedge fund quality analyses on the granular moving pieces of the natural gas production supply. This is an incredibly difficult area that will require hundreds of hours of research to accurately work out through financial modeling the decline rates, CAPEX budgets, DUC inventories, future midstream takeaway capacity, modeling the growth of renewables, understanding hydro and nuclear supply, and finally conducting sensitivity analysis on coal to gas switch for each incremental 0.25 mm/Btu in natural gas.

Again, I don't have the bandwidth or financial incentive to devote myself to this 200-hour plus intellectual pursuit. In the meantime, I would strongly caution retail investors against simply buying natural gas because it is cheap. The Masters of the Universe drove the June spot contract from $2.15 mm/Btu down to $1.92 mm/Btu and now they have driven July's contract up from $2.13 mm/Btu to $2.61 mm/Btu.

Any commodity that can move this dramatically on very thin and volatile data is highly dangerous. The natural gas stocks have already followed oil are already up pretty big, so I am not sure of any good way to play natural gas given the current investable universe.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.