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Natural Gas (NYSEARCA:UNG) prices have fallen from $4.5 (Henry hub spot price) last year to $1.82 in April, and then jumped to above $3 just when everyone thought prices were heading to zero. Volatility brings with itself great trading opportunities, which is why I am going to try and develop a model to estimate what natural gas prices might be during winter this year.

The basic hypothesis is this: The gas prices in the winter months will depend on how hot/cold the winter is, the available inventory of natural gas, and the demand for other uses. Since the demand for other uses is more or less constant on a shorter time frame, this variable can be ignored in this analysis. I am publishing the details of my analysis for curious readers as well as for people to comment and critique on it. Investors who do not want to get into the nitty-gritty of the model can directly scroll down to the conclusion.

The months of April to October are called the injection period and the number of rigs drilling for natural gas during this period will determine the inventory levels around October. So the first variable that we use is the number of rigs engaged in drilling for natural gas, which is provided by BHI Rig Count. The second variable is the inventory of natural gas available now (mid-July). We shall use regression analysis and use past data to estimate the inventory levels in October. The table below will is the data set:

Year

Rigs

Beginning

Inventory

((NYSE:BCF))

Inventory

per rig

October-

Inventory

(A)

(B)

(C)

(D)

2011

879

2671

0.96693463

3521

2010

962

2891

0.63227953

3499

2009

707

2952

0.99798061

3658

2008

1503

2396

0.5337652

3198

2007

1477

2763

0.38807116

3336

2006

1369

2763

0.4573874

3389

2005

1195

2344

0.53825548

2987

2004

1014

2227

0.85316938

3092

2003

884

1981

1.04380277

2904

2002

690

2486

0.86051325

3080

(A)- Three month average number of Rigs drilling for Natural Gas prior to the third week of July as published by BHI Rig Count.

(B)- Inventory levels of Natural gas as of the third week of July as published by the U.S. Energy Information Administration ((NYSEMKT:EIA)).

(C)- Inventory per rig is an estimation of the productivity and utilization of the rigs. For example, in 2007, 1477 rigs were in operation which lead to an increase of only 573 bcf in the inventory levels where as in 2011, 879 rigs lead to an increase of 850 bcf. Hence it is important to incorporate this variable into analysis.

(D)- This is the inventory level in October as published by the U.S. Energy Information Administration .

When we use the past 10 year data for analysis we get the following equation:

  • October Inventory = -339.334 + 0.551 Rigs + 0.927316 Beginning Inventory + 900.7051 Inventory per rig

For 2012, we have the following data:

  • Rigs = 572 (from BHI Rig Count)

  • Beginning Inventory = 3163 (from EIA)

  • Inventory per rig = 0.7 (average value for the past 5 years)

Substituting these values into the above equation we get estimated October inventory to be 3539 bcf.

In the second part of the analysis we use October Inventory levels and average winter temperature:

Year

Temp

October -

Inventory

Avg Gas

price($)

(E)

(F)

(G)

2011

32.15

3521

2.788

2010

31.12

3499

4.280

2009

33.65

3658

5.492

2008

33.29

3198

5.222

2007

33.89

3336

7.880

2006

36.1

3389

7.072

2005

35.91

2987

9.849

2004

33.61

3092

6.296

2003

34.2

2904

5.887

2002

36.35

3080

5.903

(E) - We use the average temperature during the months of December, January and February across the U.S. as published by National Climatic Data Center.

(F)- Is the October inventory level as published by the U.S. Energy Information Administration .

(G)- Average gas Price - We use the 3-month average (December, January & February) Henry Hub Natural gas spot price as published by the U.S. - EIA.

Using this data we get the following equation:

Average Gas Prices = -12.2789 + 0.68 Temp - 0.00147 October Inventory

From this stage we can use the October Inventory level that we got in the earlier analysis and use different values for the temperature to get an estimate of the natural gas prices.

Temp (deg F)

Avg Gas prices ($)

30

2.92

32

4.28

34

5.64

36.83*

7.00

*As predicted by NCDC for 2012-13.

An immediate observation, which is very counter-intuitive, is that lower temperature is resulting in lower gas price and vice-versa. However, if we observe the 10-year table published above, we see the same pattern. This emphasizes the importance of Regression Analysis since we have another variable, Inventory level, at play here.

Conclusion:

The shale gas boom in the U.S. lead to abundant supply of natural gas and prices fell to multi-year lows. As profit margins got squeezed for Exploration and Production companies drilling shifted from natural gas to oil and natural gas liquids. The latest figure for rigs engaged in drilling for Natural gas as of July 27th is 505. The last time the rig count had fallen below 500 was in 1999. Based on the model above gas prices could be significantly higher than present levels in the coming few months. If rig activity were to reduce further, the inventory buildup will be much slower changing the market dynamic from excess supply to a supply crunch giving further impetus to the price.

How to profit from it?

There can be several ways in which investors can play the natural gas price rise depending upon one's sophistication and available capital. The easiest is to buy the futures contracts on NYMEX but given that futures trading is not everyone's cup of tea, we need to explore other avenues. A much safer alternative is to buy the Natural gas ETF's among which the United States Natural Gas Fund is one of the most liquid names. Another alternative could be to take positions in E&P companies whose profitability is directly correlated to the price of gas. A few prominent names would be Exxon Mobil Corporation (NYSE:XOM), BP plc (NYSE:BP), ConocoPhillips (NYSE:COP), Anadarko Petroleum Corporation (NYSE:APC), Chesapeake Energy Corporation (NYSE:CHK), Devon Energy (NYSE:DVN), EOG Resources (NYSE:EOG), EnCana (NYSE:ECA), Pioneer (NYSE:PXD), Continental Resources (NYSE:CLR), Denbury (NYSE:DNR), Ultra Petroleum (NYSE:UPL), Range Resources (NYSE:RRC). Depending on the production mix and the geographical reach of each of these individual names, they could be more of less affected by an increase in natural gas prices.

Source: Natural Gas Prices To Be Significantly Higher Closer To Winter