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.

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