Natural Gas: Grim Outlook Through Late 2010

Includes: BHGE, ECA, UNG
by: Larry Bellehumeur

Seems like a decade ago that natural gas hit its highs in 2008. Natural gas closed at an unbelievably low price of just over $3. With the winter heating season not starting up again for another few months, natural gas seems destined to fall below $3, barring some miraculous event.

How bad is the current situation for natural gas? Here are some grim stats:

The summer time is generally a time when natural gas inventories climb, but this is worse than normal.

This makes sense, if you look at why. Natural gas wells continue to produce their normal rates, regardless of the season. Most natural gas is used for one of 3 reasons:

  • Heating of homes in some northern climates (not applicable in the summer)
  • Production of electricity (would be applicable during a hot summer, when air conditioners drive up demand.....however, most areas are having a cooler than expected summer)
  • Industrial uses (this has been greatly affected by the economic downturn)

Production should have really tailed off, but hasn't.

Based on the incredible number of rigs that have been decommissioned in North America, combined with the lack of liquified natural gas arriving, the production should have plummeted.

However, this is not the case. The latest weekly inventory levels show that natural gas production is up by over 25% over last year, and about the same percentage over the average of the last 5 years.

This has built inventory levels up to over 20% higher than even the highest part of the range for over the past 5 years. It will take a long time to burn through this inventory.

The last two years have not produced any storms that have disrupted natural gas production in the Gulf of Mexico, as Katrina and Rita did.

Although the hurricane season is relatively young (it can go up until November 1st), the "hurricane premium" has been virtually removed from the spot price.

I do see natural gas making a strong comeback by late 2010 for the following reasons:

  1. Shale = fast decline rates. Shale gas can lose as much as 50% or more of its production rate within one year. This simply means that you must punch more holes in the ground than traditional formations, just to keep the same rates of production. With the decline in prices, it simply isn't economical enough to justify drilling new holes right now, even with the incredible reduction in daily rates for most service companies. You can't hold off drilling forever before the production falls off dramatically. I suspect that production will begin to fall off in early to mid 2010. This won't likely be noticed throughout the summer, as this is a seasonably low demand period. The first noticeable time will be around November 2010, when demand will likely exceed supply, drawing down very heavily on inventories.
  2. 6:1 ratio... No one believes that oil will stay as low as $65 once the economic engines of China/India get going. So, what happened to the ratio of 6:1, which refers to the ratio that 6 units of natural gas produce the same amount of energy as 1 barrel of oil? The current ratio (over 20:1) is not sustainable, as factories/energy producers and other heavy users of fossil fuels will have no choice but to switch to natural gas as their main energy source.
  3. Cash for clunkers. Any significant uptick in aluminum and steel production (whether it is brought on by the uptick in auto production from cash for clunkers, or simply from a drop in Inventories at factories) will dramatically fire up the demand for natural gas
  4. US dollar weakness / inflationary worries. This will (indirectly) help virtually all commodities, especially those prices in US dollars. You simply cannot run the printing press for that long without weakening your currency and driving up inflation. It won't be noticeable in 2009, as no one would dare raise prices at this point in the recovery. However, it won't be long before the dollar weakens first (likely in early 2010, when the world stops using the US dollar as a safe haven) and then an increasing amount of inflation, both of which should help natural gas.

Is it too early to invest in natural gas?

Yes and no. Many companies, such as EnCana (NYSE:ECA) were smart to adopt hedging strategies and have been selling their production at a much higher rate than spot price.

However, very few (if any) companies have hedges in place past January 2010, and the likelihood of getting another great deal is small. So, even those companies who have held in fairly well to date might finally have a leg down.

While prices are down, you may wish to look at companies who use natural gas as a major source of energy, as they are likely seeing higher than expected margins due to the lower input costs. This would include utilities with a high percentage of their electricity generated by natural gas, some chemical stocks (although, this advantage may be negated by the lower demand from the economy) and some fertilizer stocks.

When the prices start to rebound, the best upside will be in the Junior plays and in the oil services. I prefer to play through the oil services, as they tend to be diversified and aren't as affected by local issues. Companies such as Baker Hughes (BHI) are highly tied to natural gas production.

Disclosure: Long ECA/BHI, no current play on natural gas futures