Bears Take Over the Natural Gas Market
Just when it looked like the U.S. natural gas market was about to establish a longer-term base, the market responded with a simple three-word reply…
“Not so fast!”
Futures contracts have turned decidedly bearish during the last several trading sessions.
Hedge fund managers have been pushing gas futures down for most of the past week, reaching $3.91 per 1,000 cubic feet (or million BTUs) at close on Friday. (This is the standard NYMEX natural gas futures contract, settled at Henry Hub in Louisiana.)
According to the latest Commitments of Traders report from the Commodity Futures Trading Commission, in the seven days ending February 8, traders’ net-short positions increased by 27%, to levels not seen since December 19, 2008. The short-only portion of those positions has more contracts in it than at any time since October 21, 2008.
These positions are bets that the price of gas will decline further.
There are a number of reasons why the market is ganging up on the short side of this equation (especially when it comes to the hedge fund managers responsible for much of the daily liquidity).
And in this price-depressed environment, there are a number of things investors should look for in gas-producing companies to find sure profits.
Why the Shorts Are Showing Up Now
First, despite bouts of bitterly cold weather across much of the U.S., the decline in stockpiles has been less than expected.
There is still a surplus of well above 2.5 trillion cubic feet, and that will depress any pricing moves to the upside. And prospects that this surplus will subside are not encouraging.
The Energy Information Administration (EIA) – the division of the Department of Energy that provides the data used in calculating trends – is telling us that the inventory stockpiles will remain for 2011.
The EIA short-term outlook calls for more than 1.65 trillion cubic feet to remain in surplus by the end of March and the traditional end of the winter heating season.
Inventories grew to record levels leading into the 2009 and 2010 winter season. The equivalent figure at the end of March 2010 was 1.66 trillion cubic feet – an all-time record that could well be matched this year.
Unlike previous surplus periods, there is now considerably more volume that can be easily brought into the market, thanks to the largesse created by shale gas. That means there is a substantial pressure against rapidly rising prices.
A price level below $4 per NYMEX contract – the level at open of market today – is low enough to prompt operating companies to reduce production. At current levels, the EIA now estimates an average price for the year of only $4.16.
Second, the weather situation is improving… and fast.
Near-term projections call for significantly warmer temperatures throughout the eastern part of the U.S., with averages some 30 degrees higher by the end of this week than the beginning of February. That will translate into a decline in demand of as much as 30% through this week.
Third, unlike the fourth quarter of 2008 – the last time we saw such a spread along the long-short gas curve – the market is not expecting an appreciable decline in demand.
Yet this time around, tanking prices are not reflecting analyst opinions that the economy is moving into a recession or that productivity will be cut.
In fact, industrial usage right now is increasing.
Of the three primary uses for gas (the other two being residential and electricity production), industrial had taken the longest to recover from the crisis. Available volume of gas production to meet it, however, has been increasing even faster.
Medium-term prospects are better. More gas will be used in the generation of power, as new emissions standards take effect in January of next year and more coal-fired capacity is brought off line.
The application of gas to transportation and the expansion of gas-based petrochemical processing will also improve overall demand, while the prospect of moving gas into export via liquefied natural gas (LNG) is also under active consideration.
The terminal at Cove Point, Maryland – the largest on the eastern seaboard – is considering a move to export LNG to Europe. (See “A Solution for North America’s Natural Gas Surplus,” November 2, 2010.) That is admittedly a move that would take a few years to develop.
Gas has traditionally been a fuel to serve primarily local markets; we are seeing that emphasized again.
That means those regions having ready access to production would fare better with lower prices, and that should prove of great advantage in enticing industry.
These days, the new sources of shale gas will have a pronounced impact on the energy balance.
This is especially the case with the game-changing Marcellus basin, centrally located in the region that was historically the most dependent on importing fuel from other areas – the Northeast.
The ultimate leverage, however, will be found in the cost of production. In a market like the one forming now, demand will actually increase. That is because we tend to use more energy when the price is lower.
In such an environment, the cheaper gas will displace the more expensive.
How to Profit
As an investor, therefore, you will want to acquire the gas-producing companies that have three common elements:
- solid gross, operating, and net margins;
- a low (and declining) debt-to-earnings ratio; and
- central focus upon primary low-cost production assets.
To achieve these three results, companies that compete successfully will all do something very much like the following…
They will cut operating capital expenditures (no reason to produce more if there is no market for it) while maintaining the status of leased acreage (for ready access to enhanced extraction when needed).
These companies will sell or decrease investment in marginal holdings, de-emphasizing locations and non-core upstream/downstream elements, applying the savings to reducing debt.
And they will refrain from exercising options or will liquidate holdings in those basins unlikely to provide a large portion of aggregate production at the most efficient per unit cost.
Because, unlike international oil majors, gas producers have little incentive to become vertically integrated.
Especially in a price-constricted market like this one.