Monday, February 17, 2014

Natural Gas At A Crossroads: Heading For A Shortage Or is The Market Still Oversupplied?

Against The Backdrop Of An Extremely Cold Winter, The Natural Gas Market Wavers

Natural gas prices have been in the dumps for a couple of years as the drillers found lots and lots (and lots) of gas reserves onshore in the US that are extractable at a reasonable cost using modern production technology.  As producers went hog wild in drilling wells, inventories piled up, prices crashed ($2/MCF natural gas was not that long ago) and natural gas consumers (utilities, chemical companies, etc.) starting burning up as much of the stuff as they possibly could.  It seemed the glut of natural gas would never go away and prices would always be low.  However, the winter of 2013-2014 has proven to be one of the coldest in a couple of decades and demand has suddenly ballooned for natural gas as heating fuel.  The overhang of excess supply is about gone as everyone tried to stay warm and prices have risen to in excess of $5/MCF for the front month future and $4 and change for the rest of the futures curve. In times past when supplies have gotten short in the natural gas (and just about every other commodity) market, it has not been uncommon to see parabolic upward moves in the price of the commodity.  However, natural gas is nowhere near panicky shortage pricing that has been seen in the past (natural gas was $20/MCF after the 2005 hurricane season), perhaps due to the view that we are still standing on a sea of natural gas and any shortfall in supply will be temporary.  Which way will natural gas prices move in coming months and more importantly how can an investor most appropriately make money off whatever direction the market moves?

There is no denying that the US has ample natural gas reserves.  Even the laziest Google search will bring up estimates of a 75 year supply at current consumption rates, ever-increasing recoverable reserve estimates, etc.  The important question is what price for gas will be necessary to induce natural gas drillers to pull the stuff out of the ground and supply the market?  That price has varied wildly over the last decade, ranging from below $2/MCF to (briefly) $20/MCF.  Technology has greatly changed the nature of the US onshore natural gas industry.  Advanced drilling techniques have increased producers' ability to find gas reserves and have greatly reduced production costs.  Entire new gas fields have been discovered (Marcellus and Utica Shales, to name two recent finds) and in many cases the only impediments to ramping up production are getting a high enough price for the gas and building out the pipeline and gas processing infrastructure to connect new wells to end users.  Gas producers were so successful in finding and producing more gas that they crashed the price of gas, landing themselves in cash flow binds and crushing their stock prices in the process.  A big part of the rush to drill was the need to fulfill the terms of the leases they struck with the owners of the land where the gas resides.  Under "held by production" terms,  the gas producers had to do a minimum amount of drilling within a certain time in order to gain a long term right to the gas reserves.  Since there was a land rush going on with several competing companies racing to secure reserves in newly discovered fields, there was a lot of required drilling going on and a consequent oversupply of the market.

However, things seem to be changing.  One of the most undisciplined land grabbers (Chesapeake Energy, CHK) ran out of cash and was essentially forced by circumstances and its capital providers to dramatically scale back both reserve acquisition and drilling activity and live within its means.  This seems to have been a watershed event for the industry as CHK's peers and competitors felt less pressure to compete for reserves and in many cases ran out of cash to continue doing so.  With less land grabbing going on, the frantic drilling of wells to hold reserves by production has gradually tailed off and drillers seem to have largely ceased such activity.  As you can see, the count of active rigs is down significantly:

There are some problems with relying on reported natural gas rig counts, as oil well drilling often results in significant incidental natural gas production.  However, it is hard to escape the conclusion that the industry has been forced to exercise more restraint and discipline in how much gas is supplied via new wells.  In the face of decade-low gas prices there is only so much the capital markets will allow you to borrow to engage in what amounts to vanity production with no obvious economic returns underpinning the activity.

Despite the ratcheting down of supply, inventories were quite heavy until the very cold winter weather of the last few months spiked demand.  Unless you live in southern California or the tip of Florida, US residents have experienced gripping cold and consequent high demand for all forms of heating fuel.  With natural gas being a popular choice for home heating, excess inventories have been burned up rapidly.  The following table shows natural gas inventories in the US in billions of cubic feet (BCF):

04-Oct-13 3577
11-Oct-13 3654
18-Oct-13 3741
25-Oct-13 3779
01-Nov-13 3814
08-Nov-13 3834
15-Nov-13 3789
22-Nov-13 3776
29-Nov-13 3614
06-Dec-13 3533
13-Dec-13 3248
20-Dec-13 3071
27-Dec-13 2974
03-Jan-14 2817
10-Jan-14 2530
17-Jan-14 2423
24-Jan-14 2185
31-Jan-14 1923
07-Feb-14 1686
Source: EIA

Supplies are now below the 5 year average for this time of year.  More cold weather has been hitting the major consuming regions (Midwest and East) lately, so significant withdrawals from inventories are likely in the next few weeks.  Traditionally, withdrawals from storage related to heating season end about April 1.  Depending on the weather, there could be a lot more withdrawals from storage before the cold weather is over.

Against the backdrop of less extensive supply, natural gas prices have risen from about $2/MCF to between $4 and $5/MCF depending on which month of the forward curve you look at.  While this is helpful to natural gas producers, even $5 gas is just enough to keep these companies alive, especially since many producers have weakened balance sheets in the aftermath of persistent low gas prices.  The industry really needs sustained $6/MCF or higher price to make solid profits, pay down debt and reward long equity positions.  What would it take to get back to $6/MCF or better?  At least in the short term, a shortage of natural gas would almost certainly do it.  With a bit more heating demand, it is entirely possible that natural gas inventories could drop below 1 trillion cubic feet (TCF) this year.  The last time inventories dropped below 1 TCF was the end of February 2003.  This shortage occurred after a prolonged period of low gas prices ($2/MCF) and a number of natural gas producers were in financial distress (sound familiar?).  The most convenient way to see the effects of the shortage on natural gas prices is via the price history of the March 2003 natural gas future:

The graph seems to have lost its dollar values, but the contract spent much of its time between $2 and $4/MCF until the shortage unfolded.  Within the space of a few months, the contract ground upward as supplies dropped and then as inventories dropped below 1 TCF the price spiked dramatically.  The contract peaked at just over $10/MCF and settled at over $9/MCF.  Gas prices subsequently settled out at about $6/MCF, sometimes higher, in subsequent months.  Since this occurred back in 2003, inflation adjusted prices would be about 27% higher in 2014.  Not surprisingly, 2003 was an extremely remunerative year for investors in natural gas equities.

Sounds pretty enticing as a long story, eh?  Of course, there is always the counter-argument.  There is no avoiding the fact that natural gas producers have been extremely poorly disciplined when it comes to balancing the supply they bring to market with demand.  Many natural gas drillers operate via a very simple mantra: if they get a dollar, they use it to drill.  It does not matter whether the dollar is borrowed, earned, raised via an equity issuance, or stolen: they use it to drill.  The few exceptions to this sorry track record include some of the largest, most profitable, most admired companies in the world (e.g. ExxonMobil).  That aside, there is definitely some possibility that the response of the natural gas industry to even modestly higher prices will be to once again flood  the market in an orgy of overproduction.  Clearly, there is a sizable number of investors who believe that this will be the case.  Many natural gas producers including CHK and Ultra Petroleum (UPL) have significant shrt positions in their shares.  This assumption is also likely a major reason why natural gas producer equities have had a restrained upward movement in the face of natural gas prices more than doubling from the lows. 

There are people and organizations who spend all their time following natural gas consumption trends, weather impacts, etc. there are very well informed analysts following trends at the well level to monitor what the natural gas producers are doing.  It is highly unlikely that I or any other generalist or retail investor will outguess the specialists.  All we can do is try to play the odds, especially when there appears to be an asymmetric risk-reward balance.  Over the past 6 months natural gas futures have risen significantly while natural gas equities have risen modestly, as you can see from this graph:

FCG is an ETF that holds natural gas driller equities, while UNG is an ETF that tracks natural gas futures.  The equities in the space have not risen nearly as much as natural gas prices even though most of these companies have material balance sheet leverage and operating leverage to the price of natural gas.  I suspect that this is because investors are not convinced that the rise in natural gas prices will be sustained and there is a good chance that the companies in this industry will soon flood the market and find themselves in exactly the same predicament they were in 6 months ago.  However, this situation offers a potentially lucrative trade opportunity.  If natural gas prices decline back to the $3 to $4/MCF range after the end of the heating season, it is likely that natural gas equities will decline 5 to 10% as they return to the valuations they had before natural gas crested $5 on the front month future.  On the other hand, if the 2013-2014 winter results in inventories falling below 1 TCF and this becomes a watershed event for the industry, natural gas equities are likely to offer outsized returns to investors.  As an example, between mid-February 2003 and mid-February 2005 CHK went from $8/share to $18/share.

Will a shortage of natural gas develop?  It is wise to remain agnostic.  However, for the first time in years there is a realistic possibility that gas prices may rise enough to take this much-beleaguered and widely-shorted industry out of its doldrums.  A position in natural gas equities via an ETF like FCG or individual company equities may offer strong potential upside in the next several months.

As always, this is not intended as investment advice.  Consult your advisors, do your own due diligence, take your own risks.  Commodity producer equities are risky and you could definitely lose money on this stuff.

Disclosure: I am long CHK equity and UPL equity and calls.

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