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We've been bearish on natural gas since the late spring and our supply / demand model for natural gas is showing an inventory build in 2009E that will be greater than expected when we first turned bearish. Obviously, though, the price of natural gas has corrected rather dramatically and a good deal of bad news is priced into the equities and the commodity. That said, as we look into 2009, there is potential for real supply / demand imbalances.

On the supply side, YTD production is up y-o-y 8%. While we are starting to see producers cut back on drilling (Chesapeake's recent announcement for one), production will not stop on a dime. The production ramp we are on this year is well above trend line and any historical norm (the producers got greedy). The growth in production has not lead to a build in inventory, so far, because demand has averaged +4% y-o-y and imports (LNG and Canada) have been down y-o-y. Low LNG imports are finally lapped in November of this year, so in the last couple of months of this year and into next year comparisons favor a building of inventory.

Demand has been robust YTD at up +4%. Currently, the EIA is estimating growth of +1.9% in consumption in 2009E. We have a hard time seeing that happening given the current economic environment. In recent history, natural gas has rarely seen much more than GDP growth y-o-y and, in fact, in tough economic times has seen y-o-y declines, such as in 2001 when natural gas consumption was down more than -4% y-o-y. In 2001, this was primarily driven by an almost 10% y-o-y decline in industrial consumption, which is not an unlikely scenario for 2009 in our opinion.

In terms of inventory, as of October 10th, we are 3% above the 5-year average, which is certainly not overly bearish. That said, we will likely see continued building of inventory into year end and in early 2009, which could take the slightly above average inventory number to well above average.

So as we look out the next 6 - 12 months, we are fairly bearish on supply and demand and our model shows a more meaningful build than consensus. Obviously a good deal of bad news is priced in already and we wouldn't recommend shorting the equities down here. But in terms of the actual price of the commodity, it is hard for us to get bullish until we can rule our forecast for an inventory build.

On the positive side, we don't want to downplay Chesapeake and its peers cutting cap-ex budgets for drilling. This is a bullish sign, but we just need to see some evidence of production beginning to decline, as a result of these actions, before we can get bullish on the fundamentals.

Daryl G. Jones
Managing Director