Natural Gas Price Spike Will Be Bigger And Come Sooner Than Expected

Includes: CHK, GAZ, UNG
by: HiddenValueInvestor

Everyone knows we have a glut of natural gas due to over-production and the fourth warmest winter in recorded U.S. history. That has led to natural gas spot prices below $2 to force down the rig count and to even force production to be shut-in by producers. People expect natural gas prices to rise from current levels when the market rebalances. But what most people are missing is the market could rebalance much faster than expected and the price spike to encourage a rise in the rig count could be much higher than anticipated. This analysis is based on assuming normal weather patterns throughout the rest of the year.

Currently, natural gas in storage in the U.S. is running around 850 Bcf above last years level. Natural gas storage is also almost double normal levels in Canada. The concern is if that glut doesn't moderate, natural gas storage capacity will max out before the injection season is over- leaving no place to store the excess gas. Potential price predictions for that situation range from $0 to a $1.50 per mcf of natural gas. Maximum storage capacity is estimated to be 4.3-4.4 trillion cubic feet and storage last year ended the injection season above 3.9 trillion cubic feet. The glut in natural gas needs to be cut by over 500 bcf between now and the first of October to avoid the potential nightmare scenario. Simple math says the glut of natural gas could turn into a deficit by October.

First and foremost, the key driver in erasing the deficit is the coal to gas switching being deployed by utilities increasing the demand for natural gas electrical generation. It is much cheaper to generate electricity from natural gas than from coal at current spot prices. All utilities that rely on coal have natural gas plants for peak demand. A shutdown coal plant can take up to 24 hours to bring online whereas a natural gas plant can be turned on in minutes. These gas plants usually remain idle during normal demand times, but are currently running all out to take advantage of the cost savings.

The estimate of electrical generation demand for natural gas is running 6 Bcf per day above last year. With all things being equal, there are 160 days between now and October 1. That alone could erase 960 Bcf of the glut, turning it into a deficit. However, parts of last summer were very hot and there was strong demand for natural gas electrical generation for about 60 days of the summer. So for about 60 days, the excess demand will be much less than 6 Bcf. Assuming the change in demand for those 60 days is zero, then the benefits from coal to natural gas switching will max out at around 600 Bcf between now and October 1, leaving a 250 Bcf glut. This will not be enough to cause the nightmare scenario, but it will be enough to potentially create a lot of anxiety and low prices.

The second key to lowering the natural gas glut is a reduction in supply over last year's levels. After averaging 2 Bcf more per day in production in January and February of 2012 vs. 2011, natural gas supply in March and April was level in 2012 with 2011 production. This is primarily due to voluntary shut-ins of natural gas from producers. With spot prices around $2, that trend should continue and could accelerate.

Additionally, low spot prices have significantly dropped the rig count in the last 3 months. According to Baker Hughes, there were over 900 rigs drilling for natural gas in the lower 48 last year. That number dropped to 631 last week with over 200 rigs laying down in the last two months alone. For example, in the Haynesville there were 95 wells being drilled in January and only 41 wells being drilled last week. There were almost 400 wells awaiting completion in the Haynesville in January and that number has dropped to 275 wells last week. In fact, the wells awaiting completions have stabilized in the last month because multiple shale completion crews have left the Haynesville for the Bakken and other shale plays.

By June the number of wells being completed in the Haynesville and other dry gas plays will be lower than last year. As the summer goes on, new gas wells being brought online will start to mirror the rig count. Natural gas shale wells have an 85% decline rate in the first year, with much of the decline happening after the first couple of months of production. In the second half of the summer, production will begin to decline in the U.S. irrespective of voluntarily shut-in wells. This could lower supply by 200 Bcf to 300 Bcf this summer vs. last summer. Heading into the fall and winter, daily natural gas supply could be 3 Bcf to 5 Bcf lower than the prior years.

If the natural gas storage glut turns into a deficit by the end of the summer, and if supply is lower than last year's by the end of the summer without the benefit of voluntarily shut-in wells, then the market will flip from discouraging production to encouraging production. So what price will natural gas prices have to rise to to raise the rig count back towards the 800 rigs needed to stabilize supply? Some think $4 mcf gas will be sufficient as plays such as the Marcellus and some liquids rich plays are profitable at those prices. Others think the all-in costs for dry natural gas plays, such as the Haynesville, Fayetteville, and Barnett shale, is closer to $6 mcf. These plays will need to be drilled in-order to create enough of a long-term supply of natural gas.

Still others think exploration and production companies are shifting their capital expenditure budgets to liquids where rigs provide $10 mcf to $17 mcf in value vs dry gas rigs. The debate is over the price needed to raise the rig count. Right now the market is priced for natural gas prices to return to the $4 range in the winter. If the market requires $6, there is a potential 50% rise in natural gas strip prices. But if the market requires $10 plus, there is a chance to have a triple or more in natural gas prices heading into the winter of 2013.

One other factor to consider is that low natural gas prices have killed the cashflow of primarily natural gas drillers. The second largest natural gas driller in the U.S. is Chesapeake Energy (NYSE:CHK) and the company is under significant pressure to raise capital. The company has already stated it plans to move its budget to liquids. Chesapeake alone accounted for more than half of the growth in natural gas production in the lower 48 [states] in the last three years.

Another consideration is smaller natural gas companies that rely on bank credit will see a sharp drop in their borrowing bases in the second half of this year and next year due to the low spot prices lowering the value of their reserves. Prices will have to rise enough to restore reserve values before the banks will lend. But because most determinations are made only twice a year, prices will have to rise for several months before many small and mid-cap companies can return to dry natural gas drilling.

Weather will be a factor in how quickly the glut is gone. The weather has been very bearish for natural gas all year. If that continues, the glut in storage may not drop enough to avoid the nightmare scenario. The above scenario is based on normal weather patterns between now and October. But if the weather were to be generally bullish between now and October, the glut will be gone before the end of the summer and the potential storage deficit going into next winter could be much greater than expected. Remember, no major hurricaine slammed into the producing region of the Gulf last year.

There are several ways to play the coming flip in natural gas prices. For the average small investor natural gas ETFs like the United States Natural Gas Fund (NYSEARCA:UNG) and the iPath DJ-UBS Natural Gas TR Sub-Idx ETN (NYSEARCA:GAZ) could be the simplest way to play the flip. But investors should be cautious that weather doesn't force the nightmare scenario in October before making a large commitment of funds.

The market will move once it is clear a deficit vs. last year is in the cards. Investors need to be ready to move before that is obvious to everyone later in the summer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.