Now that the Peabody Energy (NYSE:BTU) bonds adventures have ended, I decided to take a detailed look at the natural gas (NYSEARCA:UNG) market. I apologize in advance to the hedge fund Masters of the Universe, who have a team of Stanford Ph.Ds at their disposal that have built excruciatingly detailed supply and demand models. With an active infant and toddler, a full-time job, and a wife with a super busy job, I have neither the bandwidth nor inclination to aspire to that level of precision. Instead, with an objective mind, now that I am at peace with the sad reality that Peabody Energy will file for bankruptcy, I decided to synthesize the major moving pieces of natural gas market. I have no hidden agenda or motivation other than seeking the truth. This is purely an academic exercise where I wanted to share with the Seeking Alpha community how I think about this Rubik's cube. And finally, one other caveat before I share my finds and observations - this is my well balanced attempt to apprise the situation. Perhaps, Pareto's principle will be misapplied and I am wrong but this is an honest attempt. Removed from the burden of ownership biases, I am purely seeking to present my objective findings.
Enclosed below are net the historical natural gas storage inventory withdrawals (for the defined time periods). As we can plainly work out, the El Nino season created extremely weak withdrawals rivaling the winter of 2011-2012. If this were a more typical winter, arguably, inventories would have been 600 Bcf lower than last Thursday's 2,493 Bcf. Given that winter is by far the biggest driver of natural gas demand, historically elevated entering inventories levels combined with this warm weather have taken a severe toll. Hence, why natural gas has traded below $2 mm/Btu throughout most of Q1 2016.
Next for historical perspective, I looked at Henry hub prices for every month from January 2012-December 2015. Then I looked at corresponding monthly ending inventory levels relative to HH prices.
Next, using the EIA's March 2016 STEO, I graphed the four major demand drivers per month. This is critical from a modeling standpoint as weather and seasonality are such major drivers of demand for the residential and commercial markets. Industrial demand is much steadier assuming the economy is growing and electric burn rates are driven by the price of natural gas relative to coal as well as regulatory considerations (the impact from more combine cycle capacity adds and lower utilized coal fired plant closures). As a case and point, February 2016's residential and commercial demand was down roughly 12 Bcf/d compared to the very cold February 2015. That equates to a 348 Bcf monthly difference.
Next I looked at the EIA's supply model. I shared a snapshot of the averages for each segment for 2012-2015 as well as their 2016 estimates. As we can see, despite federally leased supply declining by 1 Bcf/d (since 2012) and net imports declining by 1.5 Bcf/d, the prolific supply from dry natural gas production has created a net 10 Bcf/d supply increase from 2012 to 2015. Everyone knows that the big supply growth drivers have been from the Marcellus and Utica shale plays.
Moving along, and because natural gas is really seasonal, given the very mild start to March 2016, I modeled conservative residential and commercial demand. I then took the four-year average for the remaining months (April-December 2016). Given the extremely low natural gas prices, I used last year's record electric power burn rates.
Here is the scary part for natural gas producers, given today's extremely elevated inventory levels, I saw inventories building another 2,730 Bcf. Now this can't happen as current storage capacity levels are thought to be 4,000-4,200 Bcf. Depending on how hot the summer is, and more importantly, how quickly producers choke off supply, we could reach inventory capacity by the summer. If approach record inventories that early in the seasons, natural gas prices will nosedive.
What is really scary is that even if we were to assume that producers collectively cut daily production by 5 Bcf per day, we could see very elevated inventory levels heading into the Winter 2016/17 heating season.
Now, of course, my model could be too conservative on the demand side. We could have a super-hot summer and demand for March-December 2016 could come in 1 or 2 Bcf/d higher, which would only lead to 300 to 600 Bcf. The only way to solve this mess is for producers to dramatically curtail production.
Unfortunately, and I am well aware of the inherent decline rates for shale wells, and that natural gas rigs are down 80% plus from their peak, we have a prisoner's dilemma. The really weak names are desperate for any cash flow as once a well is flowing, the incremental costs are low. Besides, the weak producers need to service their stretched balance sheets.
The other issue is that the marquee names like Cabot (NYSE:CBT), EQT (NYSE:EQT), and Range Resources (NYSE:RRC) are sporting very rich valuations on the assumption that they are the low-cost Marcellus or Utica producers and that they can grow production. If Cabot doesn't show production growth, then their stock gets dinged. The other issue is that because of the lack of Northeast takeaway capacity, there was a big backlog of DUCs in the Marcellus region that came online in Q4 2015 and will continue to come online in 2016 and beyond.
Next, and I shared this in a prior Peabody Energy piece, here are the actually average daily production rates for the top forty natural gas producers in North America. Unfortunately, despite the weaker names like Ultra Petroleum (NASDAQ:UPL) on the brink of bankruptcy, production didn't decline YOY.
Longer term, given the inherent shale decline rates, huge 2016 CAPEX cuts, and closed financial markets for equity/debt for the weaker players, supply will eventually come out of the market.
Unfortunately, as we can see from today's natural gas forward curve, your guess is as good as mine as to when bankruptcies and market forces will create the Darwinian flush. Based on my findings, I wouldn't touch any natural gas stocks. I want to see dozens of bankruptcies before I wade into the water.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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