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Selling the Natural Gas Rally

By  +Follow January 9, 2014 1:08PM

The recent bout of record breaking low temperatures has led to an obvious increase in the demand for natural gas and pushed delivery prices up to $4.40 per million metric British thermal units (mmbtu). These are the highest prices we’ve seen since the heat wave and drought from the summer of 2011. In fact, the Energy Information Administration reported the largest natural gas draw for the week of Dec. 13 since they began tracking it in 1994. Furthermore, many analysts expect to break this record yet again with this week’s report. However, in spite of the recent strength in the market, I believe that there are several structural reasons why this rally won’t last and that the pricing of forward natural gas will head lower from here.

Lets look at a few of the reasons that lead me to believe natural gas will be stuck in the doldrums not just in the immediate future but also for the next couple of years. Energy production has been one of the main growth industries in the US since the economic collapse and has led to the US becoming a net energy exporter as well as surpassing Saudi Arabia as the largest global energy producer. The growth of fracking has led to a 30% increase in natural gas production over the last ten years. Fracking efficiency continues to progress, which is further ramping up production while simultaneously driving down production costs. The economic boom in natural gas production has ground to a halt thanks to bureaucratic wrangling regarding export licensing of liquefied natural gas (LNG). Therefore, the boom in domestic production is bottlenecked and will be primarily constrained by North American demand.

Growing energy efficiency has exacerbated the glut of North American natural gas. The housing boom created a market full of more energy efficient structures. Completed private housing units averaged around 1.6 million units per month in 2000 according to the Census Bureau. Building peaked in 2006 with a few months registering more than 2 million units completed before plummeting to a low of 520,000 in January of 2011. This year, the monthly average was around 810,000. Clearly, the houses built since 2000 are quite a bit more efficient than the older units. Additionally, the economic rebound over the last two years has led to a surge in remodeling. The Joint Center for Housing Studies at Harvard University shows a 30% growth in home remodeling loans over the last two years. The combination of so many newly built homes along with the surge in remodeling of older homes has led to a more efficient housing sector and declining private demand.

Let’s shift gears from the big picture macroeconomic factors that will keep upward spikes in natural prices to a minimum and focus on what the market is telling us now during this spike. I believe the two best places to focus on in this respect are the spread markets which compare the current price of natural gas to the expected price of natural gas at some point in the future and the commercial trader position to see what actions natural gas producers are taking at current pricing levels.

Spread pricing of physical goods like natural gas, oil or corn are all made up of the same pricing components; storage costs, insurance costs and risk premium. These costs make up the premium that prices the delivery of future contracts higher than the, “spot” or, cash price and is generally referred to as, “contango.” The opposite situation called, “backwardation.” This occurs when the future price of a physical commodity like natural gas is cheaper than the current delivery price. When using spread prices to ascertain market sentiment the greater the contango the higher the expected long-term price. Conversely, the greater the backwardation, the more prices will be expected to collapse.

Currently, the natural gas market shows a mild degree of contango in the front months (nearby delivery) while backwardation appears the farther out we look in the pricing structure. Therefore, the spread market is suggesting a mild degree of current demand, which is expected to decline.

Commercial traders are keenly aware of this situation and their collective selling of forward contracts in the futures market reflects their bearishness. Commercial traders have sold more than 40,000 contracts in the natural gas futures in the last week and more than 80,000 contracts since the August low. I expect to see their selling continue to climb as the market trades near the pivotal $4.50mmbtu level. Commercial traders have been very successful in their overall analysis of the natural gas futures market. I have posted a chart illustrating their actions on our site at Andywaldock.com.

I think the structural case for lower natural gas prices has been clearly laid out. Until Washington gets its act together and the US can begin exporting liquefied natural gas on an industrial scale we will continue to see natural gas producers selling rallies as these will be their only opportunities to guarantee that their future production will be sold at a profit. Furthermore as fracking costs continue to decline the breakeven costs of producers will follow suit thus lowering the prices they’ll be able to sell their forward contracts driving prices even lower, perhaps below $2 per mmbtu.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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By  +Follow January 9, 2014 1:08PM



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