I have read a lot of fast and loose talk about how La Nina will magically work off the current natural gas inventory surplus of 2.972 Bcf (NYSEARCA:UNG). For historical perspective, inventories are now seasonally 718 Bcf higher than the five-year averages. Despite this, certain bullish authors appear to be exercising wishful thinking and may not fully understand the moving pieces and math relating to electric power burn.
As I argued in a recent piece, the only way to solve this inventory glut is through meaningful supply cuts. The problem then becomes if tangible evidence of supply cuts emerges then this could have negative implications for (short-term) equity prices of natural gas midstream and producing companies. Accurately modeling these potential supply cuts is beyond the scope of this piece given the incredible intellectual horsepower and time required to even attempt. Natural gas production is so fragmented that you would need to have a thorough database of all the cumulative natural gas, NGLs and crude wells. Next you would need to understand the production characteristics and vintages of each. I will leave this to the trading Masters of the Universe who collectively trade billions of dollars worth of natural gas futures and derivatives.
Before we dive into some of the natural gas power burn, let's put into context the seasonality of how natural gas inventories move through the year. By my simple calculations, there are now possibly 22 more weeks of injections until we reach early November. The five-year average builds from weeks 24 - 45 are 71.86 Bcf per week.
Now we physically can't build this much inventory as 71.86 Bcf x 22 weeks equal 1,581 Bcf. The reason we can't hit this number is that inventory storage capacity is only 4,100 Bcf, so if we averaged 51 Bcf per week over the next 22 weeks then we would be at/ near capacity. In other words, the margin of error is 3 Bcf/d (21 Bcf per week / 7 days) compared to the five-year averages and we still end up at full capacity entering winter in early November 2016.
Everything I just stated is pedestrian and widely known. The volatility in natural gas prices between $2 mm/Btu and $2.75 mm/Btu will be driven by short-term noise, how speculators are positioned, and more clarity on future production/supply cuts. If the market determines we can avoid reaching capacity by October then $2.50 mm/Btu to $3.00 mm/Btu makes sense given the uncertainty of winter. The opposite also is true depending on the trajectory of builds.
The devil's in the details and all regions are not the same. What might keep natural gas bulls up at night is the elevated inventory levels in the South Central Region. As of last Thursday's release this number is now 1,244 Bcf. I understand the big seasonal demand for cooling in that region during the summer, but I'm not sure how much storage capacity is left there.
Moving along, I took a closer look at the underlying daily electricity demand for the month of June and its various generational components. Enclosed below is the chart containing five years of history and the EIA's June 2016 estimates. As I pointed out, with rising natural gas prices, coal becomes competitive at $2.50 - $2.75 mm/Btu. The problem with the thesis that a hot summer magically erased 500 Bcf in excess natural gas inventories is that nuclear, renewables and others now account for approximately 33% of electricity generation. Therefore, at least in the short term, it is tug-a-war for market share between coal and natural gas. I understand that Powder River Basin Coal has lower Btu heat rates, but using historical aggregate date, I calculated approximate sensitivities.
Given that electricity demand doesn't move that much in June, if utilities burn approximately 5 million more short tons of coal then this equates to roughly 2.22 Bcf/d of natural gas. If natural gas prices were higher then there is plenty of spare capacity for utilities to burn another 10 million short tons per month during the summer.
Concluding thought: Resist the narrative that La Nina will magically melt away 500 Bcf of excess inventories. I will do some more modeling in late June or early July relating to July and August power burn. That said, there's plenty of excess coal-fired generational capacity waiting in the wings as insurance against rapid natural gas price swings. And given that utilities are sitting on large coal inventories, especially relative to current baseline demand, they should be inclined to burn more coal. As I have argued, it is all about supply cuts. Increased Mexican imports and Cheniere's (NYSEMKT:LNG) two trains aren't enough in 2016. The demand story is more of a 2017 event.
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.