A Colder Than Normal Winter Should Throw Natural Gas Into Backwardation

| About: The United (UNG)
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Groupthink can prevent investors from seeing the obvious. Last spring it was accepted conventional wisdom that natural gas would run out of storage capacity in the fall, causing a collapse in spot prices. However, the coal to gas switching numbers and the falling rig count production numbers indicated by arithmetic that much of the glut in natural gas storage compared to the 5-year average would disappear by the end of October. In April I pointed out the Natural Gas Price Spike Will Be Bigger and Come Sooner Than Expected. At the time prices for the front month natural gas futures contract on the NYMEX had dropped to $1.90. Now it is back above $3.40. The falling rig count production numbers and with some sustained coal to gas switching due to new EPA regulations shuttering older and smaller coal plants indicate a significant deficit will arise in storage by the end of the winter if winter weather is just slightly colder than normal.

Currently, natural gas futures prices remain in contango. Contango is when spot prices for a commodity or front month futures contracts are priced lower than the futures price for contracts for months later in the year. An entity that like the United States Natural Gas Fund (NYSEARCA:UNG) that keeps investing in front month contracts during contango loses value over time as they have to pay up to get into the new contract. Backwardation is the opposite situation, the front month contract is priced higher than future months. A strategy of rolling into the new front month contract will gain value over time during backwardation as it takes less money to buy the next contract prior to expiration. Commodity contracts normally go into backwardation when the market perceives limited near-term supply versus demand. Accepted conventional wisdom is natural gas prices will remain in contango. But the arithmetic with a slightly colder than normal winter says otherwise.

If natural storage falls below the average range of the five year average the market will become very concerned about having adequate storage for the 2013-2014 winter. At that point near term natural gas prices will rise more than longer term prices to encourage every well that is capped to be turned on and every well awaiting completion to be completed as soon as possible. As of September 28, the EIA reported natural gas was still 281 Bcf above the 5 year average. But natural gas was well over 800 Bcf above the 5-year average at the end of March. Since the end of March the natural gas storage glut has decreased by close to 600 Bcf from a combination of declining production and coal to gas switching. At the same pace natural gas would be below the average range of the 5-year storage average by the end of March. With the rig count falling to 434 natural gas rigs production will continue to decline between now and March. A drop of an average of 2 Bcf per day in natural gas production between now and the end of March would cause a 360 Bcf drop in storage compared to the 5-year average assuming normalized weather. A colder than normal winter can easily eat up another 1 Bcf per day dropping storage another 180 Bcf per day compared to the 5 year average. At this point natural gas prices will rise to whatever level is necessary to increase the rig count back over 700 to try to fill storage for the next winter. Conventional wisdom in the natural gas market is not ready for this, but the arithmetic says it is a real possibility.

The companies best positioned to benefit from a rise in natural gas prices are those with a substantial portion of their production in natural gas and not liquids. Companies like Chesapeake (NYSE:CHK), Ultra Petroleum (NASDAQ:UPL), Devon Energy (NYSE:DVN), Crimson Exploration (NASDAQ:CXPO), Magnum Hunter Resources (MHR), Southwestern (NYSE:SWN), Equitable (NYSE:EQT), and Cabot Oil & Gas (NYSE:COG) all fit this profile.

Disclosure: I 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.