Monday, August 31, 2009

Natural Gas-I've changed my tune

The last 4 weeks of inventory reports have gotten progressively more bearish. In my previous post making a bull case for natural gas, I calculated that there was a supply/demand imbalance of roughly 25-30 BCF per week. After accounting for changes in weather, it appeared that the supply/demand disposition was very bullish through July. However, that imbalance has since completely disappeared. So now we have a very distended inventory (which is bearish) and a flow that is neutral (rather than bullish.)
It is still likely that natural gas will bounce back to the $5 area in the near future, but that is already priced into the strip (January natural gas is already at $5) so there is no money to be made on that expectation. The fact that back months have continued to hold up so well in price may be evidence that we are still a good distance from the next bull market.
Generally speaking, bull markets are born out of pessimism, and the steep contango (Dec 10 futures are more than double Oct. 09 futures) is still evidence that the pessimism does not exist. We have started to see some selling in the back months over just the past couple of days. Whether this turns into something more serious remains to be seen, but the capitulation in the front month has not yet been matched by capitulation in the back months.
There are other signs that lead me to believe we are in a bear market. Mergers and acquisitions are proceeding at a snail's pace in the energy sector. This is another sign of lack of capitulation, and until we see mergers, gas companies will likely continue to try to bleed each other into submission. Witness Aubrey McClendon's recent comments at a Chesapeake conference call:
I think the second thing is, given where storage is it was our analysis that we are going to be full up on storage by the end of the year. As we get closer to that, pipeline pressures are going to increase and that is going to cause involuntary curtailments. I think our view was that there was no reason for us to voluntarily curtail gas, when pretty soon, everybody is going to start involuntarily curtailing gas and so, we didn't see any reason to take it on the chin for the team, more than we did and instead, we will just let the system work, to spread the pain across the whole industry here over the next couple of months.

While prices did bounce back relatively quickly from their absolute lows in 1999 and 2002, there was still a 6-12 month period after that before prices really took off. Also, looking over the data carefully, it seems the industry is more concerned with stock of storage than the flow of storage. Prices don't bottom until the excess stock of storage over normal has come in by 200 BCF or so. And bull markets don't seem to start until stocks of storage return to their 5 year average.

And finally, I'm still waiting for some sort of pronouncement from a major media source (time, newsweek, etc.) that we have infinite amounts of natural gas, and it will serve all of our future energy needs. Publications like that often mark extremes in sentiment and price.

So, we are in a bear market. Before the bear market ends, there will be a number of signposts, and they are:
1) We need to see a less steep strip, and would particularly like to see some more backwardation between March 10 and May 10.
2) We need to see lots of gas driller/producer bankruptcies, and a high level of M&A.
3) Storage excess over norms needs to reduce by 200 BCF before prices will bottom. This will probably happen going into October as inventories get full.
4) Storage levels need to return to 5 year averages before a bull market can really get started.
5) Some sort of marker from a major media outlet would be a nice confirmation, although they don't always occur.

Sunday, August 30, 2009

Two items of interest for dollar followers

There were two news items this week that have potentially substantial implications for the US dollar.

The first is that a new political party, the Democratic Party of Japan, has swept into power in a landslide election victory. While these results will not be a surprise to the markets, it is a potential concern for the dollar. This is because the DPJ has a much cooler stance on Japan's relationship with the US, and certain officials have taken the stance that Japan should reduce its exposure to dollar holdings.
More recently, officials from the DPJ have seemed more reticent about the possibility of dumping the dollar, focusing as usual on the assumed valuation effects of their savings. I still don't understand how they are savings if the act of spending them reduces their value. This truth underlies how the currency manipulators of the world will get their comeuppance. This election is not a direct threat to the US dollar, but the new power in Japan at least pays lip service to increased flexibility in their relationship with the US and monetary issues. If you want to read a op-ed piece from the leader of the party you can do so here:

The second item has to do with announcements made by the Chinese sovereign wealth fund CIC.
It appears that the CIC is starting to increase its risk exposure, and thus far the investments seem to favor non-US entities. A short list of the possible investment already made include Teck Resources limited, Canada
and Songbird Estates PLC, England. The fund also has been active in the domestic banking market, and is rumored to be looking at Japanese equities. The reason that this has implications for the US dollar is simply a matter of asset preferences. If the CIC uses cash equivalents (the majority of which are dollars) to purchase equity and to finance debt (the majority of which are not denominated in dollars) then this will depreciate the dollar, all else equal. We saw the reverse of this in the financial crisis last fall when US and non-US entities both liquidated non-US investments in order to cover dollar obligations and to raise dollar liquidity. So long as we avoid a further financial crisis, the tide on asset preferences will now be heading in the other direction, and the CIC purchases and planned purchases are an excellent and important example of this.

From a technical perspective, the dollar is in an ambiguous stance. The recent break below below 78.5 in the dollar index was short lived; however, the rally since then has also been lackluster. We now sit at the support area around 78.5. As trading picks up in the next couple weeks, we will likely see a new trend develop. A higher dollar is likely (but not a sure thing) if the market perception starts to lean toward a further deflationary contraction of the economy. Likewise, a lower dollar is likely if the market perception continues to expect a market expansion.