Natural gas (Henry Hub) has been on a tear lately. Since bottoming out around $1.90 in April we have witnessed a >70% rally to a recent high of $3.28, interrupted briefly by a 3-week correction to $2.17. Clearly something quite significant is at play here. There is renewed bullish talk and excitement about power demand driven by the record setting summer temperatures. Technically there is an inverse head and shoulder downtrend reversal pattern on the chart. We are close to the end of summer heading toward storage peak, let's take a quick look at prior assumptions and whether or not they still make sense.
Recall that back in the milder than normal winter of 2011/2012 gas price broke 3 bucks amid historically high dry gas production. Then gas storage began to tick up much earlier than usual in the Spring and gas price continued its downward grind toward $2. Gas storage overfill prediction fueled the downward momentum and gas producers frantically moved rigs from gas basins to oil/liquids assets seeking return. Eyes were focused on whether production cutback and summer cooling power demand could come to the rescue. Where are we now?
Production: It was widely believed that producers would drastically cut back on gas production to support prices as many of the active basins could not sustain drilling and production at prices below $3. There were big announcements made by big operators such as Chesapeake Energy (CHK) of curtailment of as much as 1 Bcf/d.
Looking back at the production data the past few months, it was apparent that while ever more efficient drilling rigs were removed from gas wells they were moved to oil and NGL wells that produce plenty of offsetting associated gas. Although very generic, the rule of thumb is that associated gas from 3 wells is roughly equivalent to 1 gas well. With imports and conventional production pretty stable, the relentless rise of gas production from unconventional shale plays has resulted in a fairly flat production rate this year, despite the curtailment talk. Going forward, there is little reason to expect a significant reduction of supply to make a difference. In fact, there are many wells that have been shut in due to low commodity prices that are itching to come back online, thereby acting as a price check.
Storage: The theoretical working storage is about 4,400 Bcf (though demonstrated capacity is close to 4,100 Bcf), and we are sitting on 3,217 Bcf as of July 27. Back in January, pundits were making prediction that an overfill scenario would take a mini-miracle to avoid. The latest EIA forecast points to a 4,000 Bcf storage peak scenario. Depending on weather going forward, it is very likely that we will come close to the 4,100 number that produces a scare much like 2009, when price dropped 42% in a month. One difference between stocks/bonds and hard commodities such as natural gas is that the prices are still largely representative of exchanges of physical goods. What this means is that if we approach the storage peak season in late October/early November with a level close to the physical storage limit, there is a danger that producers can scramble to offload gas causing a short-term panic.
Weather: Several months ago, it was widely forecast that this summer would be hotter than normal but not hotter than last year. This has largely held true. Week after week of heat wave has helped burn lots of gas.
The difference between this year and last is that gas was above $4. It is widely believed that the bulk of coal-to-gas fuel switching at power plants happens in the range of $2 to $3. We have so far witnessed a significant increase in the utilization of gas fleets, evidenced by the chart below. Analysts estimated that the shares of natural gas and coal in power generation are quickly approaching or have achieved parity in 2012. Bear in mind that the US experienced a vast build-out of combined cycle gas turbines (CCGT) power plants in the last decade and most of them are underutilized. If nothing else year 2012 is educating us how much and how fast these fleets can pick up the slack when coal and gas are in competitive range.
Summer Power Burn (Bcf/d), May1 - Sep 30 Source: EIA
Meanwhile, August is shaping up to be another hot month. It is not extreme and most of it is going to be felt in the Midwest. With gas hovering near the $3 mark, there is a natural price ceiling as we approach the end of summer.
What About Hurricanes?
As recently as June, mainstream forecasters called for a below-average to average hurricane season. Of course, without knowing where a particular storm hits the degree of accuracy in forecasting production disruption and its impact on price is far too uncertain. Hurricane Ernesto is making its way to Yucatan as we speak and is not expected to cause much trouble. The Gulf of Mexico produces about 4.4 Bcf/d. Judging from the minimal impact from Tropical Storm Debby related shutdown earlier, Ernesto does not appear to make a big splash.
Fundamentally, there is currently no near-term upside catalyst for natural gas. Although one can argue that the inverse head and shoulder chart pattern is a classic sign of bottom it is important to understand the drivers of change, combine with technical analysis, and take the high probability bet. Translating this to the stock market, the picture is slightly more bearish due to the near-term sentiment related to general economic news. Gas-heavy producers have been mired in a year-long down trend. Companies such as Comstock Resources (CRK), Bill Barrette Corp (BBG), Goodrich Petroleum (GDP), Exco Resources (XCO), QEP Resources (QEP) had resorted to various financial and strategic maneuvers to maintain competitiveness. There are more short-term troubles ahead as banks' price decks revised and year-end reserves written down.
Looking forward, however, the picture is much brighter. The supply glut should come to end, likely in 2013, especially if we get a real winter. The beauty of the US market is its dynamism. Through creative destruction, mergers & acquisition, re-emergence of domestic chemical/manufacturing industries, LNG export, even natural gas vehicles, demand should meet supply fairly soon. But no one can afford to drill below cost for long, not even ExxonMobil.