As of late natural gas has been treated to similar price action as crude. From more than $5/MMBtu in mid-June or $4.70/MMBtu as recently as mid-November, prices have fallen to as low as $3.27/MMBtu as I write this (January 2015 contract). With such a quick drop, some might be tempted to think that perhaps we've gone too far. In my opinion, we haven't, though there might be one factor which might help things by mid-2015. Let me explain.
One of the things which kept natural gas well bid going into the winter season (hence those recent $4.70/MMBtu), was the low levels of natural gas in storage, themselves the result of an harsh 2013/2014 winter which led to storage levels hitting record lows as much as 1000 Bcf below the levels of the prior year.
This harsh 2013/2014 winter had a further effect. It led to production freeze-offs during December 2013. Thus, not only was there increased demand for heating, but you also had lower production for a while.
Fast-forward to the present winter. Temperatures are higher - indeed, they've been easily exceeding normal temperatures over a significant portion of the U.S., as shown below (Source: EIA)
To this we then have to add the fact that with these higher temperatures, you get no freeze-offs. So comparatively speaking, you get much higher natural gas production versus last year. And on top of that, natural gas production had already been increasing slowly all year. It all adds up to the following picture:
So on top of a production ramp due to the higher prices available during early 2014 leading to more drilling, we now have a significant year-on-year jump as the base includes shuttered wells and today's production doesn't.
A 9% year-on-year jump in natural gas production is something massive, given that demand is rather stagnated, and indeed short-term demand for heating is lower than last year due to it being warmer. This, too, has consequences, namely on the storage side:
In short, this dynamic quickly wiped out the one thing which was supporting natural gas prices - the low levels of natural gas in storage.
Then, going forward we have one unknown and one known factors:
- The unknown, is whether the weather remains warmer than average. If it does, then it will quickly lead to rapid accumulation of excess natural gas inventories;
- The known, is that natural gas production will continue growing due to inertia and a comparatively low base the year before, even if the freeze-off effect is now going to go away leading to a lower year-on-year growth rate.
These two effects lead me to believe that natural gas will choose between a bad and a worse outcome in terms of price.
The bad outcome will come from increased production even as inventories accumulate. The worse outcome will come if, on top of that, the warm winter continues. As such, even after the recent natural gas plunge it seems way too early to consider buying natural gas. Conceivably, we can still get a significant glut going forward into 2015.
A positive effect
Not all of the news for natural gas are bad news. There is one positive effect for natural gas still looming in the horizon. It has to do with the effect of significantly lower crude prices.
As crude implodes, this will drive a substantial drop in drilling for shale crude, which has quickly become uneconomic. This dynamic has already started. The much lower drilling should then quickly lead to overall shale production declines (which happen at a rate of up to 80% per year for new wells) overwhelming new shale crude production. In time, this will mean that shale crude production should stagnate and then decline if the current crude prices don't go away.
It will also lead to one other consequence: many shale oil wells also produce associated natural gas. Less drilling for shale crude and production declines from existing wells will thus also lead to somewhat lower production of associated natural gas. This will over time be a positive in helping the natural gas market regain its balance.
A combination of higher production and lower demand due to a warmer winter are hitting natural gas.
Unfortunately, the higher production will remain with us for a while, and the inventory buffer which could help natural gas prices is now gone. This means that even at today's lower natural gas pricing, there's still substantial downside risk if a natural gas glut materializes during 2015.
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The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.