Conclusion: While it is not quite at our price, natural gas is broken from a quantitative perspective and negative fundamentals continue to build and loom.
While I was out on vacation last week, the research machine at Hedgeye continued to grind forward. Our Energy Sector Head (who is launching next month) Lou Gagliardi, continued to hit the team with updates from the global oil patch. Lou forgets more about the energy industry in a day than most of us will ever know, so his thoughts are always insightful and worth reading. I’ve borrowed from his notes to outline our key negative fundamental case for natural gas in the report below. In summary, the bearish case is threefold: growing inventory, accelerating production, and likelihood of a future step down in future demand.
Production – Over the past five years in the United States the advancement of drilling technology has allowed domestic gas producers to dramatically ramp up production due to the ability to access more diverse natural gas basins, in particular shale areas. As a result of this advancement in technology, we have seen a step up in the amount of natural gas produced in the domestic United States. Both 2008 and 2009 showed domestic production levels of north of 20 million Mcf for the full year. The last time we saw this type of production was in 1974! As a result of technology and massive shale development, we are in a new paradigm of natural gas production in the U.S., which will serve to keep a lid on the upside to the price of the commodity. We have highlighted this point in the chart immediately below, which shows monthly production going back to 1997.
Looking forward production growth is also poised to accelerate in the U.S. based on rig count. Since March 5, 2010, rig count has been growing on a year-over-year basis. In fact, since the second week of July, rig count in the U.S. has been up more than 40% versus last year every week and currently there are 985 natural gas rigs operating in the U.S. The more drilling that occurs, the more that future production will grow.
Inventory – Natural gas stocks closed this week at 3,012 Bcf, which surpassed the 3,000 Bcf mark for the first time since January 1, 2010. While we are heading into the period in which there are seasonal builds of natural gas, storage levels remain at the high end of their 5-year range. The five year maximum for the most recently reported week is 3,142 Bcf, the five year minimum is 2,816, and the average for that period is 2,816. Currently, inventory in the U.S. is sitting at 7% above its 5-year average, and just 4% below the maximum.
The maximum levels of natural gas in storage occurred last year. In fact, on August 31, 2009, natural gas hit a record for August of 3,352 Bcf in storage, but currently levels are slowly inching towards those levels. Interestingly, despite the fact the inventory levels are nearing 2009 record levels and production is poised to accelerate given rig activity, the price of natural gas is well above levels of 2009. In fact, the September 2010 contract is currently priced about 49% higher than the expiration price of $2.84/MMBtu for the September 2009 contract.
Demand – Given that natural gas is a domestic based commodity, it is primarily driven by economic growth within the United States (and also coal prices which lead to switching in power plants). As we have aggressively been articulating, we believe the U.S. economy is poised to slow sequentially, which will be negative for energy consumption. Slow growth in the U.S. has a negative impact on natural gas price. In fact, as we wrote on August 11th, 2010:
“We also took a quick look at the returns of natural gas, the commodity which is priced domestically and most directly impacted by U.S. economic growth. Not surprisingly, the results were very similar. For this analysis we were only able to look at the past 10-years of data, but in the four years with the highest GDP growth in that period the average year-over-year price gain for natural gas was +16.8%, while in the four years with the lowest GDP growth prices declined an average of (-3.4%) year-over-year.”
The statistic above is likely not surprising given that more than 1/3rd of natural gas use in the United States is used for industrial purposes, which are highly dependent on economic growth.
In the chart below, we’ve highlighted a price chart of natural gas with its TREND line at $4.49 as of the open today. While we aren’t short currently, given the negative fundamental backdrop and bearish quantitative set up, we will likely be looking to short at, or around, that level.
Daryl G. Jones