Natural Gas Fails To Reach $3 And Falls To A Support Level

About: VelocityShares 3x Long Natural Gas ETN (UGAZ), Includes: BOIL, DGAZ, FCG, GASL, GASX, GAZB, KOLD, MLPG, UNG, UNL, XLE
by: Andrew Hecht

The end of the summer of record production - China’s 25% tariff.

Output not showing up in inventory numbers.

Time is running out.

The forward curve is cheap.

Look for higher lows - more liquidity equals lower volatility.

The little engine that could, couldn't over recent sessions, as the price of natural gas failed to reach the $3 per MMBtu level and declined to the middle of its trading range since mid-June.

October natural gas futures hit a high of $3.025 on June 18 and fell to a low of $2.6880 on July 19. On August 14, in a repeat of a mid-month move to the upper or lower end of its trading range, natural gas futures reached a peak at $2.979, and after attempts to challenge the June high and level of technical resistance, the price fell back to lows of $2.83 last week.

There continue to be bullish and bearish factors at play in the energy commodity. Inventories are at the lowest level in years, while production is at a record high. The midpoint of the range since for most of 2018 in the October futures contract is at just under $2.86 per MMBtu, and the energy commodity closed last week at $2.88 in the middle of the trading band.

The end of the summer of record production - China's 25% tariff

The summer of 2018 has come to a conclusion with the Labor Day holiday on Monday, September 3. In the natural gas market, the summer season was a time where production of the energy commodity rose to a record level. Technological advances in fracking, fewer regulations, and corporate tax reform has reduced costs and increased profits for natural gas producers in the United States. Then quadrillions of cubic feet of reserves in the Marcellus and Utica shale regions dramatically increased the supply side of the fundamental equation in the natural gas market.

At the same time, increased demand from the replacement of coal with natural gas in lots of power generation in the United States and exportation of liquified natural gas or LNG to areas of the world where the price is much higher has increased the demand side of the equation.

Last week, China said that they are considering slapping a 25 percent tariff on U.S. exports of LNG to the Asian nation, which may have contributed to some selling in the natural gas futures market over the past week.

Source: CQG

As the daily chart of October NYMEX natural gas futures highlights, the price dropped to a low of $2.83 per MMBtu on Wednesday, August 29, but the price reversed and rallied over the final three days of last week closing at the $2.92 per MMBtu level on Friday. Technical metrics are in neutral territory, but open interest is at a record high at over 1.6 million contracts as we move into the fall season. The end of summer means that the number of weeks left in the 2018 injection season is dwindling with stock levels at a very low level for this time of the year.

Output not showing up in inventory numbers

The record level of production is not apparent in the stockpile numbers reported by the Energy Information Administration each week. Last Thursday, the EIA told markets that stocks increased by 70 billion cubic feet for the week ending on August 24.

Source: CQG

As the chart shows, total stockpiles of 2.505 trillion cubic feet are 20.5 percent below last year's level and 19 percent below the five-year average for the end of August. With inventories significantly lower than in past years, demand has to be eating away at the record output from natural gas producers.

Time is running out

We are now past the halfway mark in the 2018 injection season. With the summer coming to an end, the demand for cooling and electric power is likely to decline leading to more substantial stockpile injections in the coming weeks. However, with only 10-11 weeks to go before the 2018/2019 withdrawal season that begins in November, producers are going to need to pick up the pace when it comes to building inventories which remain at noticeably low levels.

Last year, stocks peaked at 3.79 bcf in November, and to reach that level this year, we will need to see an average weekly injection of 116.9-128.6 bcf for the balance of the stock-building season. To climb to only 3.4 bcf, the average will need to reach 81.4-89.6 bcf depending on if there are ten or eleven weeks left until stocks begin to decline. The 3.4 tcf level to start the season of peak demand could prove a reach if we do not see a significant increase in injections in September.

I expect to see at least a few triple-digit builds in stockpiles, but if this does not occur, a cold winter could have an explosive impact on prices. In February 2014, the price of natural gas rose to a high of $6.493 per MMBtu on the back of cold weather conditions and low stockpiles. In late August 2013, total inventories stood at 3.131 tcf, 626 bcf above the current level which is a reason to consider the potential impact of a colder than average winter season on the price of the energy commodity.

The forward curve is cheap

The forward curve in the natural gas market continues to reflect the market's perception that increased production and new pipelines will keep a lid on prices, even if the coming winter season turns out to boost demand.

Source: CME/RMB

As the term structure for the natural gas market on Friday, August 31 shows, the price for the coming winter season peaks at $3.116 per MMBtu, and the highest price on the board that goes out to a maturity of December 2030 is the January 2030 price at $3.407. In late January 2018, the price of the energy commodity peaked at $3.661 on the nearby contract. A peak price that is 25.4 cents lower than that level over a decade into the future is a surprisingly low level given the current level of inventories and potential for price volatility in the natural gas markets.

The energy commodity has a long history of wide price variance. Since 2014, the price has traded in a range from $1.611 and $6.493, with a midpoint at just over $4. Therefore, the current level of the forward curve in the natural gas futures market displays the market's bearish sentiment.

Look for higher lows - more liquidity equals lower volatility

I have been writing that increasing liquidity has stomped on price volatility in the natural gas futures market. Increased production and consumption have caused both open interest and volume metrics to rise to record highs. In the world of futures, increasing liquidity tends to have a depressive impact on price volatility. In 2005 and 2008, the price of Henry Hub natural gas futures that trade on the NYMEX division of the CME rose to above the $10 per MMBtu level, with the high coming in 2005 at $15.65.

Those days are long over in the market, but the potential for the energy commodity to reach $4 or $5 during a frigid winter season that increases demand for the energy commodity and causes inventories to decline to dangerously low levels is possible.

The weekly inventory report is going to begin to take on a lot more significance over the coming weeks as we head towards the heart of the fall season. If injections do not start to increase appreciably, it is likely that the price of natural gas will make higher lows and higher highs.

Source: CQG

Weekly historical volatility in the natural gas market is the 13.26 percent level as of last Friday. The daily measure of price variance was below 17 percent. Since the primary determinate of option premiums is implied volatility and implied is often a function of historical volatility, call options in the natural gas market for the coming winter months of January through March remain at inexpensive levels.

I am continuing to trade in the natural gas futures market and using the short-term triple-leveraged UGAZ and DGAZ highly liquid ETN products to grind profits in the natural gas market as it continues to trade in a range from around $2.70 to $3.00. I am investing all of my profits in call options for the coming winter season to try to parlay small, short-term profits into a medium-term home run in the natural gas market with a low degree of risk.

The price of natural gas failed again at the top end of its trading range at $3 per MMBtu over the past week. However, the price to the midpoint of the recent range at just under the $2.85 level and bounced back over $2.90. Fasten your seatbelts in natural gas; we could see lots of volatility over the coming weeks after the EIA releases its weekly inventory data. Higher numbers could start pushing prices lower, but a continuation of the trickle that has dominated the market throughout the 2018 injection season is destined to support the price of the energy commodity.

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.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.