Back at the end of April I wrote that the Natural Gas Price Spike Will be Bigger and Come Sooner Than Expected. That article predicted the natural gas storage glut could turn into a deficit versus both last year's storage and the 5 year average by October. If so, then this would avoid the fear that storage demand would exceed capacity creating a significant drop in natural gas spot prices. The call was based on an assumption of a 6 Bcf per day increase of demand for natural gas for electrical generation due to coal to gas switching economics and an eventual decline in supply. The two biggest variables affecting the call would be weather and price allowing for coal to gas switching. Whereas the weather was bearish for natural gas in May, it has turned decidedly bullish for natural gas in July. Over the last three months the spot price for natural gas has risen from $1.90 in late April to $3.10 in late July. While the storage glut rose to 880 Bcf near the end of April, it has since dropped dramatically to 435 Bcf versus the 5 year average according to the latest Weekly EIA Natural Gas Storage Report. Lat year's storage capacity was in excess of 4.1 Bcf per day and natural gas storage ended the injection season at 3,852 Bcf. This year working gas storage capacity design is estimated to be between 4.3-4.4 Bcf and demonstrated capacity is 4.1 Bcf.
If current trends continue not only will demand for natural gas storage stay below capacity, but the natural gas glut will turn into a deficit by the end of October. With half of the deficit erased in the last three months natural gas remains on a path to erase all of the storage deficit before the end of October. The weather will remain an unknown variable. However, natural gas spot prices consistently over $3 will lead many electrical generating companies to switch back to Powder River Basin coal, since it will become more economical than gas above $3. Powder River Basin coal accounts for 40% of the U.S. coal supply. Therefore, if prices for spot natural gas keep rising the extra demand for natural gas for electrical generation will drop from the 6-7 Bcf it has averaged in the last few months to 3-4 Bcf. There are 100 days left from the last EIA weekly storage report until the end of October. Even a sustained increase of 3-4 Bcf will drop storage another 350 Bcf all things being equal. The economics for switching back to Appalachian coal from natural gas starts to kick with natural gas spot prices between $3.50-$4. Should natural gas trade above $4, then most of the coal to gas switching will disappear.
The other major factor affecting storage between now and the end of October is supply. Earlier in the year when natural gas prices fell below $2 multiple companies shut-in some production to reduce supply. Most of the shut-in production is back online with gas prices back above $3. In July of 2012 daily natural gas supply for the lower 48 is averaging 69.5 Bcf per day, which is similar to last year. But last year daily natural gas supply increased 1 Bcf per day on average each month from August-October due to production increases from a rig count averaging 900 natural gas rigs. As talked about in my previous article the price of natural gas and the financial difficulties of many natural gas drillers, especially Chesapeake (CHK), has caused a dramatic fall in the rig count. For example Encana (ECA) was just forced to write-down its natural gas reserves by $1.7 billion due to price. It is now a little over 500 natural gas rigs and has continued to fall even though the price of natural gas has risen back to $3. Even the countries most lucrative natural gas play, the Marcellus Shale, has seen a fall in the dry gas rig count. The vast majority of the rigs dropped so far are those drilling for dry gas, which produces the most natural gas per well on average. Many of the remaining 500 rigs are drilling for liquids rich wet gas, which consists of natural gas liquids, dry gas, and sometimes oil. That means not has the number of wells being drilled fallen, but the average amount of natural gas production per drilled well has also fallen. Hence, going forward we should see a steady decline in daily natural gas supply. Annual supply depletes around 32% with no additions to production. This means the U.S. must drill for an extra 21 Bcf per day per year just to maintain a steady rate of supply. The drop in the rig count means we could start losing 1 Bcf per month of supply through out the rest of the year. This would mean the drop in daily production could reduce gas added to storage by another 200 Bcf per day by the end of October, which would turn a glut into a deficit.
If the natural gas storage glut turns into a deficit by the end of the summer, and if supply is lower than last year's by the end of the summer without the benefit of voluntarily shut-in wells, then the market will flip from discouraging production to encouraging production. So what price will natural gas prices have to rise to raise the rig count back towards the 800 rigs needed to stabilize supply? Some think $4 mcf gas will be sufficient as plays such as the Marcellus and some liquids rich plays are profitable at those prices. Others think the all-in costs for dry natural gas plays, such as the Haynesville, Fayetteville, and Barnett shale, are closer to $6 mcf. These plays will need to be drilled in-order to create enough of a long-term supply of natural gas.
Still others think exploration and production companies are shifting their capital expenditure budgets to liquids where rigs provide $10 mcf to $17 mcf in value vs dry gas rigs. The debate is over the price needed to raise the rig count. Right now the market is priced for natural gas prices to return to the $4 range in the winter. If the market requires $6, there is a potential 50% rise in natural gas strip prices. But if the market requires $10 plus, there is a chance to have a triple or more in natural gas prices heading into the winter of 2013.
Weather will be a factor in how quickly the glut is gone. The weather has been very bearish for natural gas most of the year, but has recently turned very bullish due to the extreme heat in the corn belt. The above scenario is based on normal weather patterns between now and October. If the weather were to remain generally bullish between now and October, the glut will be gone before the end of the summer and the potential storage deficit going into next winter could be much greater than expected.
There are several ways to play the continuing rise in natural gas prices. For the average small investor natural gas ETFs like the United States Natural Gas Fund (UNG) and the iPath DJ-UBS Natural Gas TR Sub-Idx ETN (GAZ) could be the simplest way to play the run. But investors should be cautious that weather doesn't force the nightmare scenario in October before making a large commitment of funds.
The market will move once it is clear a deficit vs. last year is in the cards. Investors need to be ready to move before that is obvious to everyone later in the summer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.