Weekly Report – Natural Gas Mid-Year Recap

2 July 2012


2012 has thus far proven to be eventful, with risk of war with Iran flaring up (and then dying down), continued banking and sovereign debt crises in Europe, and rapidly changing supply-demand dynamics across both oil and gas in the U.S. The remaining 6 months of the year are promising to be just as interesting, as the same factors mentioned above persist in the marketplace.

In this edition, we will focus our attention on natural gas, with a separate report on crude oil prices to follow shortly.

NATURAL GAS


Henry Hub natural gas prices are down over -17.73% this year, at $2.543 per mmBtu, as of June 22nd.  Natural gas made headlines in April after being down as much as -40.77%, spending several days below the $2 watermark and reaching a bottom on April 19th at $1.831—the lowest price in a decade.

This April’s low was even lower than the previous decade bottom made on August 31st, 2009 when futures contracts closed at $1.920. The April 19th bottom represented a 61% decline from the year’s high. Prices have since recovered 38.88%, and continue to exhibit strong technical momentum, despite macroeconomic and fundamental supply-demand conditions that are not quite robust.

Why is natural gas so deep under water?

The main price driver for natural gas at the moment is the massive supply overhang persisting in the U.S. As of May 2012, working inventories were an estimated 2.9 trillion cubic feet, or more than 31 percent higher than May 2011 levels. To put that into context, Trinidad and Tobago has an estimated 30 trillion cubic feet of total natural gas reserves—the U.S. has 10% of T&T’s gas in storage.

These inventories are a function of the rapid increase in production of gas from shale and other non-conventional sources. The U.S. Energy Information Administration estimates that 2012 gas production will be 23 trillion cubic feet, or a 27.4% increase from 2005 levels.

Increased production and overcapacity, in conjunction with economic weakness, has led to declining prices and higher volatility. U.S. producers have taken steps to curtail their production of natural gas, in order to help reduce the glut. As seen in the graph, between September 2011 and April 2012, production first levelled off and then decreased, as new drilling programs were postponed and existing wells left temporarily idle or operating below capacity.

Volatility increases during weather events that disrupt production (hurricanes or uncommonly cold weather in producing areas) or increase demand (heat waves and winter storms). Volatility also typically increases whenever there is positive or negative macroeconomic news.

Implied volatility is a measure calculated from futures and options prices, while historical volatility is calculated as the standard deviation in prices during a specific period. They do not always move in sync but implied volatility often takes the lead with historical (or realized) volatility catching up to it eventually. Once the two measures of volatility converge, the probability of a big price swing increases. Currently, implied volatility and historical volatility are both above 50—in other words, volatility is expected to continue to be high.

The remainder of the year could see some upside in natural gas, if production cut trends continue. Electric utilities are also helping the natural gas price, as it is now extremely attractive relative to coal not only on a cost basis but also environmentally—especially important in an era of increasing regulation. Longer term, natural gas prices are expected to be substantially higher than they are today due to the high likelihood that the U.S. will begin LNG exports and increased usage of natural gas by utilities.

Natural Gas Futures Curve


Additionally, there are increasingly vocal calls for the introduction of natural gas as a vehicular fuel, especially for the massive U.S. truck fleet, who are major consumers of fuel as well as emitters of CO2 and other greenhouse gases. Lastly, increased opposition to fracking (a method of extracting gas from shale) will add to the existing and planned production cuts to curtail output, ultimately providing a boost—or at the very least help shore up—natural gas prices.

In the midst of current market conditions, there are several short term and long term investment opportunities in the stocks and bonds of natural gas producers.  Contact Firstline Securities to learn how you can profit from prevailing trends and conditions.

Michael J. Cooper
Trading & Investment Strategist
Firstline Securities Limited

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