Natural Gas: Downside Risks Continues To Outweigh Upside Potential As Cold West U.S. Vs. Mild East U.S. Holds Strong Through Mid-February

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Includes: BOIL, DGAZ, KOLD, UGAZ, UNG, UNL
by: Andrei Evbuoma
Summary

Thursday's inventory draw of -237bcf comes up slightly short but still in line with consensus expectations of -245bcf.

Bears remain in the driver seat as Cold West U.S. vs. Mild East U.S. to hold through at least February 20.

Bulls struggle to find a strong catalyst with no signs of Arctic cold coming anytime soon across the East U.S.

Investment Thesis

Despite the deep selling of natural gas (UNG), the commodity has not yet found its bottom. Forecast models continues to support a Cold West U.S. vs. Mild East U.S. pattern persisting through at least February 20 lending support to the bears and short positions in UNG, (DGAZ), and (KOLD).

Natural Gas Market Recap - UNG, UGAZ, BOIL Under Heavy Pressure

Natural gas, driven largely by the weather pattern, has been in steady decline as of late. Since last Wednesday’s (January 30, 2019) open, the front-month March 2019 contract has fallen 36 cents from $2.91 to $2.55 as of Thursday's close. That includes a 6 cent drop ($2.91 to $2.85) on Wednesday, another 6 cent drop ($2.87 to $2.81) on Thursday, a 10 cent drop ($2.83 to $2.73) on Friday, a 5 cent drop ($2.71 to $2.66) on Monday. After Monday’s close, the market has been flat right around the $2.66 mark through Wednesday. The $2.66 was the lowest of this heating season and the lowest since April 19, 2018. After Thursday morning's storage report, natural gas prices declined about 4% or 11 cents to settle $2.55, making it a new low for the season and the lowest in over 2 years (since August 11, 2016). Needless to say, it has been all bears as of recent. In fact, outside of the cold November 2018 and the late January cold (Jan. 20-31), this heating season has been all bears with a mild December, overall mild January, and what appears to be shaping up as an overall mild February (given more days up to Feb. 20 are to be warmer than normal across the East US). Figure 1 below is a depiction of the front-month March 2019 contract price trend since January 30.

Figure 1: March 2019 contract price trend since January 30.

Source: Investing.com

As of Thursday’s close, UNG was down 3.85% to $22.95, (UGAZ) down 11.8% to $27.48, and (BOIL) down 7.9% to $19.86. On the flip side, its inverses' DGAZ and KOLD have been fared extremely well as of late. As of Thursday’s close DGAZ finished up 11.58% to $121.53 and KOLD up 7.93% to $23.83. Figure 2 is a price trend comparison between UNG, DGAZ, KOLD since February 1.

Figure 2: UNG, DGAZ, KOLD price trend comparison from February 1.

Source: Seeking Alpha

Bull speculators were hoping that last week’s Polar Vortex, which resulted in several record low temperatures from the Midwest to the East Coast and a preliminary record high heating demand last Wednesday of 145.1 billion cubic feet per day (Bcfd) across the Lower 48, would be a catalyst to spark a rally. But because of its small coverage and short duration, it just did not have enough support to reverse the downturn as forecast models last week pointed towards a quick flip in the weather pattern to a Cold West U.S. vs. Mild East U.S. (which has verified and resulted in dramatic 70+ temperature swings earlier this week over many population centers across the eastern half of the nation).

In a time that is so critical now for the bullish speculators, sentiment across the natural gas space has increasingly become more bearish as short-medium range computer models continue to support a Cold West U.S. vs. Mild East U.S. pattern persisting through at least February 20. In addition to the forecast models, there are other weather variables in play that lends support to the bears. Simply put, downside risks ARE outweighing upside potential.

Forecast Models Alongside Other Variables Provide Strong Catalysts For The Bears

One observation I've noticed within the forecast models this winter season has been the cold bias in the medium to long range timeframe. There's been a pattern where the cold has underperformed as forecast models initially project cold in the medium to longer range only to walk back the cold with a milder solution as we draw closer in time. Because of that, I've been tempering my expectations on the severity of cold shots in the medium and long range.

There are several variables that I will re-visit and introduce in today's article that lends greater support to the bearish speculators. The first variable is the Polar Vortex (PV). After a major sudden stratospheric warming event (SSWE) in late December and resultant PV split early January (that led to the cold pattern about a month later in late January including last week’s record breaking cold), the PV has since recovered and retreated back to its original position (the North Pole). This is bad news for the bulls or those wanting a cold winter as a strong PV means a cold North Pole and a mild pattern over the northern continents (e.g. North America, Europe, Asia) while a weak PV means a warm North Pole and increased odds for cold air outbreaks and a cold pattern over the northern continents. Figure 3 is a depiction of the position of the Polar Vortex from the 06z GFS model.

Figure 3: Polar Vortex location as depicted on the 06z GFS.

Source: InstantWeatherMaps

The Arctic Oscillation (AO) is a teleconnection that directly reflects the situation in the Arctic (North Pole). A negative AO, which we are currently in now, corresponds with a warm Arctic, a weakened PV, and thus the chance for cold across the northern continents (North America, Europe, Asia). A positive AO signals the opposite. The AO is expected to transition to a positive phase within the next week. This corresponds to a strengthened PV, a colder Arctic than current, and the likelihood for mild weather across the northern continents.

The second variable we will revisit this week is the Madden Julian Oscillation (MJO). The MJO is currently in a phase 6 and will be in a phase 6/7 for the better part of the next 2 weeks (over the next 10 days or so). A phase 6/7 of the MJO signals a Mild East US vs. a Cold West US. During the 11-15 day period, the MJO shifts into a phase 8 which supports a colder pattern over the eastern half of the country. This looks to occur around or after February 20. There are timing and strength differences between the GFS and the ECMWF as the GFS is slower in the transition from a 6 to an 8 while the ECMWF is faster in the transition. The GFS also favors a strong phase 7/8 while the ECMWF favors a weak phase 6-8. In terms of timing, the GFS version seems to be the better of the two as forecast models are more in line with that idea. Figure 4 is a image of the observed and 15-day forecast phase and position of the MJO.

Figure 4: MJO observed and 15-day forecast phase and position.

Source: UAlbany

This is actually one variable that initially supports the bears, but would later in the 11-15 day favor the bulls should this forecast verify. The GFS and its ensemble (GEFS) both indicate the pattern turning colder across the northern and eastern U.S. in the 11-15 day. Something to keep an eye on!

The next variables I want to discuss is the sub-tropical jet stream (southern branch jet) that stretches from the equatorial Pacific, through Mexico into the southern and eastern U.S. This variable, because of where it's coming from, provides a mild pattern over the southern and eastern U.S. Coinciding with this weather feature is a prominent, strong (esp. for this time of year) sub-tropical high centered over Cuba and stretching as far north as the southeastern U.S. If this was the summer, we would be talking about a heatwave over the southeastern United States. This feature also supports mild weather across the southern and eastern U.S. in that it helps to usher in a return flow (southwest flow or air coming from the south) into the southern US and eastern US. This also connects well with the +NAO phase that I introduced in my blog post and last article. The NAO by the way is projected to remain positive over the next 2 weeks.

Another variable that I will discuss is the Pacific North American Oscillation (PNA). Currently, it’s in a negative phase which supports the current Cold West US vs. Mild East US pattern. Forecast has it remaining in a negative phase over the next two weeks. Figure 5 is a image showing the observed and 15-day forecast phase of the PNA.

Figure 5: Observed and 15-day forecast phase of the PNA.

Source: NOAA

In addition to the PNA, there is another teleconnection that along with the PNA is strongly influencing our current and near term weather pattern. This teleconnection is called the Eastern Pacific Oscillation (EPO).

It’s a variation of the atmospheric flow pattern across the northeastern Pacific and Alaska. When in a positive phase, either a trough is present over the northeastern Pacific into Alaska or the jet stream flow is flat allowing for mild Pacific air to flow straight into the U.S. west coast. This results in a mild or warm central and eastern U.S. A negative phase (like we currently are in) is when a ridge is present over the northeastern Pacific into Alaska or the jet stream pattern is amplified in that region. This upper level feature blocks mild Pacific air from reaching the west coast and instead allows for air to tap into very cold Arctic air over Alaska and the Arctic region before sending it southward into Canada. This results in colder than average temperatures across much of Canada and the northern U.S. with the core of the cold typically located over western Canada into the Rockies which is the type of pattern we are seeing now.

Lastly is the forecast models. Currently, we have a Cold West U.S. vs. a Mild East U.S. pattern unfolding with the bulk of the cold being confined across the Northern Rockies and Plains and western Canada. This weather pattern is driven by a variety of variables including a -EPO/negative East Pacific Oscillation and a -PNA/negative Pacific North American Oscillation that I mentioned above. The latest computer models suggest this pattern staying in place through at least February 20. There will be transient cold shots here and there (ex: Feb. 8-9) that makes its way eastward across the Midwest and Northeast U.S. during this time period but overall the pattern will be mild. Heating demand from any cold shots will be on the light side. Figure 6 below is an illustration of the 6-11 day weather pattern (Cold West U.S. vs. Mild East U.S.) averaged out from February 13-18 from the 0z ECMWF EPS model.

Figure 6: 0z ECMWF EPS 6-11 day weather pattern setup averaged from February 13-18.

Source: Weatherbell

Figure 7 below is a depiction from the 0z ECMWF EPS model of temperature anomalies 5,000ft above the surface averaged out in the 6-11 day timeframe or from February 13-18. (Cold West U.S. vs. Mild East U.S.)

Figure 7: 0z ECMWF EPS 6-11 day 850mb temperature anomalies averaged from February 13-18.

Source: WeatherBell

Figure 8 below is a depiction from the 18z CFSv2 model of surface temperature anomalies averaged out in the 8-14 day timeframe or from February 14-21. (Cold West U.S. vs. Mild East U.S.)

Figure 8: 18z CFSv2 8-14 day surface temperature anomalies averaged from February 14-21.

Source: TropicalTidbits

Final Trading Thoughts - Gas Prices Expected To Decline More, Storage Deficit Gap Expected to Narrow

Natural gas prices have been under heavy pressure lately falling 36 cents to $2.55 since January 30. Despite the fact that natural gas has undergone deep selling with technicals suggesting that he commodity is deeply undervalued and thus should be poised for a rally, it is the fundamentals that drive the market ultimately. Given what we know, that is the several atmospheric variables mentioned above, the fact that the cold has largely underperformed this winter season (cold bias in the models medium to long range), and the fact that the weather pattern over the next two weeks will feature a Cold West U.S. vs. a Mild East U.S. configuration with no signs of any breakthrough, Arctic cold coming to the major population centers of the East Coast, there is still more downside risk than upside potential. I’m reluctant to say that prices have found a bottom.

Because of that, my new price target for the front-month March 2019 contract is $2.65 with a range over the next week or so between $2.65 and $2.25. UNG should trade between $24.00 and $19.00. To investors, my strategy remains unchanged. The short positions should still be heavier weighted in your portfolio with small long positions. For investors with a one way approach, I continue to sell any rally. For the more bullish investors, I would have some small long positions or just a wait on the sidelines approach and look forward to and/or make preparations for this upcoming summer that should provide opportunity for UGAZ and BOIL.

The Energy Information Administration (NYSEMKT:EIA) have come out Thursday morning with its weekly natural gas storage report for the week of January 28-February 1 (or week ending Feb. 1). The report showed an inventory draw of -237bcf slightly below but still in line with consensus of -245bcf. This puts current inventory levels at 1,960 bcf, 415 bcf below the 5-year average of 2,375, and 135 bcf below last year (2,095). The region with the biggest draw was the Midwest with -84 bcf due to the Polar Vortex. Figures 9 and 10 below are both depictions of Thursday's EIA's natural gas storage report for the week of Jan. 14-18.

Figure 9: Thursday's (Feb. 7, 2019) EIA Natural Gas Storage Report (Table Format) for week of Jan. 28-Feb. 1, 2019.

Source: EIA

Figure 10: Thursday's (Feb. 7, 2019) EIA Natural Gas Storage Report (Graph Format) for week of Jan. 28-Feb. 1, 2019.

Source: EIA

Below, I have developed and installed my own natural gas withdrawal/injection, inventory levels, and deficit projections for this article. You can expect to see this moving forward in future articles.

For this week, I projected a withdrawal report of -225 bcf. Figure 11 below shows my natural gas inventory withdrawal projections over the next 4 weeks vs. the 5-year average and the total 4 week projected level vs. the 5-year average.

Figure 11: Natural Gas Weekly Storage Injection/Withdrawal Projections over the next 4 weeks.

Source: Andrei Evbuoma

Figure 12 below is the observed or current NatGas inventory level and my forecast levels over the next 4 weeks vs. the 5-year average.

Figure 12:Observed and 4 week projected natural gas inventory levels.

Source: Andrei Evbuoma

Finally, figure 13 below is the current storage deficit level and my 4-week projected deficit levels.

Figure 13:Observed and 4 week projected natural gas storage deficit.

Source: Andrei Evbuoma

Stay Tuned For More Updates!

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.