Emotions are running high for natural gas traders after the fireworks of the past six weeks. I'm currently on the sidelines, and, while I'm long term bearish, nothing goes up or down in a straight line. A relief bounce on colder weather is possible, but not guaranteed. Sentiment can always get worse. The remaining Titanic passengers clinging to the back of the ship were extremely negative and they were 100% right.
Please do your homework before you enter a commodity trade. The risk is high. I strongly advise new investors to explore the best production companies with exposure to both oil and gas. Names like Cabot (COG) and Pioneer (PXD) come to mind, and Cheniere Energy (LNG) (CQP) is in a unique position to benefit from 'lower for longer' natural gas prices via Sabine Pass and their expansion plans. Many love the excitement of trading the leveraged ETF products. This series of articles will help investors in both categories as we focus on short and long term strategies across the energy universe.
Future production indicators for North American natural gas include:
- Drilling rig count: Updated weekly by Baker Hughes and available for free. If you haven't looked at the pdf from their website, do yourself a favor. It contains invaluable details like shale basin breakdown that are rarely covered in the headline news articles. Knowing the difference between the Permian and Appalachia matters.
- Drilled Uncompleted Wells (DUCs): the EIA publishes a monthly drilling report which is essential reading for energy investors.
- WTI Oil Pricing/World Oil Pricing: West Texas Intermediate (WTI) pricing is an integral part of the equation for nat gas due to associated production from oil drilling. WTI pricing relative to year ago levels provides a useful indicator for associated production trends. Given the substantial growth in U.S. refined product exports, we also need to track world oil pricing via the Brent/WTI spread.
- Midstream expansion/contraction: Midstream refers to the network of pipelines that move energy commodities from production centers to refineries, local distribution companies (LDCs), export facilities, etc.
- Canadian Production: We'll save this topic for deeper analysis in a separate article.
Current U.S. lower-48 state (L48) production is bumping against all time highs near ~76-77 bcfd after bottoming near ~70 at the start of 2017. This is not a surprising number if you've been following the future production indicators.
The rig count crashed following Saudi Arabia's attempt to crush L48 shale production with their market moving decision to flood crude worldwide in November 2014. Dramatically lower crude prices had the desired impact with rig counts plummeting worldwide and hitting bottom in mid-2016. Since then, the rig count has recovered substantially leading to Clue #1, more drilling.
How can we be sure the rig level is adequate to maintain current natural gas production levels? Clue #2, DUCs have risen substantially the past eight months. Specifically the Permian basin has a giant DUC inventory that appears to be growing out of control with no end in sight. This will impact Waha hub pricing and nat gas supply for Mexico and the gulf coast, more on this later. The most important basin is Appalachia formerly known as the Marcellus and Utica shales. The DUC count for Appalachia is showing slightly positive growth at a level that's ~75% of the ATH DUC count for this region. Although DUCs are down from ATH's, it's hard to consider this bullish with Appalachian output strong at ~27 bcfd. Since Rover partially came online in September, total Appalachian output keeps setting and breaking production records on the back of new midstream capacity. The scary fact if you're bullish is that Rover is effectively only half done and there are many more Appalachian expansion projects coming online over the next 9 months. All of these projects are designed to free additional supply from this low-cost production juggernaut and get the gas to premium markets in every direction. This is a key reason why the natural gas curve has been stuck in the mud and trending lower.
WTI pricing has held above $55, and the stock charts for many of the oil focused majors and medium caps is a strong signal that higher oil pricing is here to stay leading us to Clue #3. Strong WTI vs. year ago pricing means associated gas production is likely to rise. Even worse, WTI pricing is not impacted by nat gas pricing. Natty could go to zero and you'd still get associated output if oil remains strong. The Permian basin is located in West Texas close to Mexico and the gulf coast. Permian associated production will go a long way to feeding new demand for LNG exports and Mexports.
Donald Trump's election had an immediate impact on North American energy markets leading us to Clue #4, major midstream expansion projects. The Obama administration slowed pipeline development frustrating many investors and gas industry executives who knew the potential of Appalachian output. This changed dramatically in February 2017 when FERC surprisingly approved various pipeline efforts that were held up on bureaucratic red tape. Consensus at the time was that most midstream projects would be delayed by at least a year due to the administration switchover. The most important project was ETP's Rover pipeline designed to move gas to the key midcon market and then into the massive Dawn hub in Canada. FERC switching gears from a headwind to a tailwind overnight was a big red flag for natural gas bulls. Much has been written on SeekingAlpha regarding the impact of midstream projects. It's an important area to stay on top of if you invest in oil and gas.
The fundamental forces of gas production are undeniably leaning bearish as shown by the trail of clues laid out above. Does that mean gas can't rally? Hell no. The most important force in the natural gas market is Mother Nature. Extremely cold weather is needed to offset bearish production levels and reinforce damaged bull psyches. Pricing is weak because December-2016 was an extremely cold month with large EIA inventory withdrawals that were well above the five-year average. Current December temps started off warm leading to the surprise EIA injection reported this past Thursday. If you were on top of future production fundamentals, you were not surprised warm temps allowed the bears to maul the poorly prepared bulls. Difficult December 2016 storage comps were destined to be a problem that would allow the EIA y-o-y storage differential to contract significantly heading into year end. I'm expecting the EIA y-o-y storage gap to shrink to less than 100 bcf by January 1st.
The most important question is what happens next and how do we profit from it? I started this article stating I was safely on the sidelines wearing a helmet and protective gear. I don't like the risk/reward for either side. When it comes to investing, there's no Medal of Honor for being the first hero through the door. Investors who bought Apple (AAPL) in 2010 when the first iPad was released are just as happy as buyers during the 2008/2009 financial crisis. The best advice right now is keep watching the tape to see what the big players are doing. These "Elephant Tracks" are impossible for big traders to hide given the huge volumes they move entering and exiting positions. My next article will look at critical inflection points over the past 24 months, and the signals indicating a trend reversal is probable.
The next 10 days will be interesting watching the market react to more typical December weather balanced against mixed longer term forecasts. I don't see a sustained rally until we have lower production along with substantially lower rig counts and DUC inventories. My fear is sub $2.50 Henry Hub prices could be needed to send the STOP NOW signal to overzealous producers in the absence of colder weather. Extreme cold from now until April 1st would help absorb the extra production, but after two warm winters and a dicey December 2017 start, traders are wondering if Mother Nature is shorting futures in her own account.
Key Data Points:
EIA storage projection for 1/1/18 = 3,220 bcf +/- 35 (based on NOAA CFSv2 four week forecast as of 12/10 morning update & EIA historical data)
~3,220 on 1/1/18 leads to ~1,690 bcf finishing storage estimate in late March 2018 using the five year EIA average withdrawals. For reference the March-2017 finish was 2,049 bcf.
Conclusion: Current EIA storage trends are taking a back seat to future production fundamentals. The market is worried about two things:
- Producers will do what they've always done through past cycles, over produce.
- Substantial new midstream capacity from prolific, low cost shale basins like Appalachia and the Permian will act as an anchor tied to the leg of the Henry Hub.
Thank you for reading.
Disclosure: I am/we are long LNG. 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.
Additional disclosure: I frequently trade leveraged ETF products in the commodity space.