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.

http://seekingalpha.com/article/153691-chesapeake-energy-corporation-q2-2009-earnings-call-transcript?page=3

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.

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. http://www.bloomberg.com/apps/news?pid=20601068&sid=acmzAQiv_eQI
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:
http://www.csmonitor.com/2009/0819/p09s07-coop.html

The second item has to do with announcements made by the Chinese sovereign wealth fund CIC. http://bloomberg.com/apps/news?pid=20601208&sid=a4FINX22BV8c
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.

The Bullish Case for Natural Gas Prices

1. Supply and Demand
2. EIA inventory reports – why aren’t they bearish anymore? Over the past 2 weeks, demand is outstripping supply by 25 BCF/week, and the infamous NG glut would disappear in 16 weeks at that rate.
3. Supply: rig counts. Rig counts continue to fall. Since supply continues to fall even after rig counts start to grow again, we can be assured that supply will continue to fall for at least another three or four months.
4. Demand: If the recession has in fact bottomed, then we can expect natural gas demand to boomerang higher, as economy wide production levels are currently below economy wide consumption levels, and inventories are down 10% YOY. Inventory/sales ratio is still higher than it was in 2006-2008, so industrial demand may remain weak in the short term.
5. Previous examples of rig lay downs, their duration, scope, and the related price action. There are two cases where the number of rigs decreased by 40-45% (1999 and 2002). They were both in similar periods of excess gas storage and the correlated low price. In our current situation, the number of rigs has decreased by 59%(‼)There is a gap between where a company will lay down a rig and start one up again. It requires a significant move higher in price before companies will increase the rig count. If a company will lay down a rig at $4, they won’t necessarily put it back into operation until $5 or even higher. In previous examples, prices moved by 50-75% off their lows within 2 months.
6. Technical price support for a bullish conclusion
7. Conclusion

1. Supply and Demand

On Thursday every week, the Energy Information Agency (Note that all the data presented in this report are taken from the EIA unless otherwise noted) releases national storage data for natural gas. This report is an important data piece for traders and economists who are looking for clues to the supply/demand disposition of natural gas. The inventory follows a similar pattern every year, whereby inventories build from late March to mid November, and then draw down quickly during the cold winter months (Figure 1).
Figure 1 Natural Gas Storage (Source EIA)

Note the cyclical nature of gas inventories. Since the spring and fall has neither excessive heat nor excessive cold, these periods are called the shoulder months and have the least demand for natural gas. Demand is elevated in the summer due to air conditioning, but inventories still grow in the summer, just at a slower pace. Since the expected number of degree days is different in every calendar week, the most meaningful comparisons of natural gas disposition are achieved by comparing the same week in different years. Additionally, other factors affecting demand (holidays and scheduled industrial furloughs) generally fall in the same calendar week and are neutralized by comparing year over year data.
While comparing the same week on a YOY basis can provide “first-order” estimation for changes in supply and demand (footnote 2: When speaking of supply and demand in this paper I do so informally; I intend to mean quantity supplied (excluding changes in inventory) and quantity demanded. Thus if I say “supply exceeds demand by 20 BCF” the reader can take it to mean that, ceteris paribus, the quantity supplied is 20 BCF greater than the quantity demanded, and that difference is made up by inventory levels) , it will only give an accurate depiction averaged over many weeks of data. This is because one finds that even in the same calendar week the weather can vary greatly from one year to the next. Therefore, a more sophisticated approach must account for changes in weather between the two years. This is done by constructing a regression using weather data as explanatory variables and inventory changes as the dependant variable. Once you know the predicted effects of changes in heating and cooling demand, you can then back out a decent estimate for the year over year change in supply and demand disposition.

2. Why The EIA reports aren’t bearish anymore

First two weeks of July 2009 (i.e. the last two inventory reports)
Average cooling degree days for the past two weeks=62
Average inventory fill for the past two weeks=82.5
First two weeks of July (2006-2008)
Average cooling degree days for the first two weeks= 75
Average inventory fill=85.5
Look at the difference in cooling degree days between this year and the average over the past 3 years (62 versus 75). How big of a difference could that make in cooling demand?
That big of a difference in CDDs is good for about 25 BCF less use per week,
(Footnote 3
I ran a least squares regression using the difference between changes in inventory in two consecutive years as the dependant variable and changes in heating degree and cooling degree days as the independent (or explanatory) variables. I use terms for the differences in the square of the CDDs and HDDs as well to allow for a non-linear relationship (for example, if 10% of the population uses an air conditioner at 80° F, but 50% use an air conditioner at 90° F, then a linear specification won’t give us as accurate of a specification). The equation generated by the least squares regressions to explain inventory changes based on differences in degree days is the following:
d(dINV)= -2+0.97*d(HDD)+0.79*d(CDD)+0.0013*d(HDD^2)+0.0096*d(CDD^2)
where:
dINV=change in EIA natural gas inventory from one week to the next
d(dINV)= difference in dINV for a given week, between year x and year (x+1).
d(HDD)=difference in Heating Degree Days for a given week, between year x and year (x+1).
d(CDD)=difference in Cooling Degree Days for a given week, between year x and year (x+1).
D(HDD^2)= difference in the square of the HDD for given week, between year x and year (x+1).
D(CDD^2)= difference in the square of the HDD for given week, between year x and year (x+1).

The fact that the constant term at the beginning of the equation is -2 instead of 0 reflects the fact that we have had a YOY inventory build of approximately 100 BCF per year over the past three years. In the long run this constant term will equal 0! end footnote)


so based on simple weather YOY comparisons, we would have predicted fills in the 110 range over the past two weeks. Instead we got 82.5, a fact that signifies less gas was put in storage than what is predicted based on the regression.
Based on the past two weeks of data, and assuming the regression is roughly accurate, demand is outstripping supply by 25 BCF/week or almost 4 BCF a day! Normally this level of discrepancy would create an absolute panic in the market. However, because the stock of natural gas is currently 450 BCF above average, the market reaction was muted. Still, the price has moved up 10% since before the release of the July 3rd inventory report.
One way to think of the current situation is to parse the bearish or bullish reality in terms of stock versus flow.
The stock:
Stock of natural gas is 450 BCF above normal. VERY BEARISH
1st derivative (The flow):
After accounting for changes in weather and other exogenous factors, I estimate that demand has outstripped supply by 25 BCF/ week for the past two weeks. Over the past 4 weeks, demand outstripped supply by 21 BCF/week. While four weeks is a small sample size, this level of discrepancy is statistically significant. Future inventory reports will continue to confirm, deny, or accelerate this apparent disparity between supply and demand. BULLISH

2nd derivative (change in the flow):
In 2009Q1, the supply demand disparity was the opposite: supply outstripped demand by 40 BCF/week. Thus, in one quarter, the market went from a 40 BCF/week surplus to a 25 BCF/week deficiency. Obviously, this implies the second derivative of the stock (change in the change of the stock) is negative and steeply so. Why this is and whether it will continue will be the focus of my discussion in sections 3 and 4. BULLISH

In summary, if a trader were to focus only on the stock of natural gas, they will see a 450 BCF glut. Examples of natural gas prices getting driven into the ground during the fall shoulder months abound (and under much less extreme storage gluts then the current one). However, if the trader considers the flow (1st derivative) and change in flow (2nd derivative) a different perspective emerges. Assuming the previous calculations are accurate we are currently running 25 BCF/week below expectations, at which rate the entire storage glut would be gone in 18 weeks. If the 2nd derivative (change in flow) is negative, then the glut could disappear even faster. How can we estimate which effect will dominate prices in the near future? Well, this is not the first time the market has been in this scenario: we had a natural gas glut in both 1999 and 2002, and history can be our guide. In section 5, we look for possible rhymes in these previous instances to divine the probable outcome of our current situation.

3. Rig Counts

Every week, Baker Hughes publishes the number of active gas rigs operating in the world and in the United States. This rig count data correlates with the number of new gas wells that can be expected to be drilled in any given week. In order to simply maintain supply, a certain number of rigs need to operate. The necessary number depends on the initial flow rate of new wells, and the depletion rate of the existing resource. If the number of new drilled wells goes above this number, then supply well increase, and vice-versa. One of the important metrics to know is what the average depletion rate is in existing wells. Unfortunately, that piece of data is extremely difficult to calculate because there are so many types of wells in different types of rock and the overall distribution of quality and type is constantly changing. What we do know is that
1. Depletion rates steadily increased between 1980-2006 (see http://www.eia.doe.gov/oiaf/servicerpt/depletion/pdf/app_g.pdf and
http://gswindell.com/tx-depl.htm)
2. Average flow rates have been decreasing over the past 30 years (Figure 2)
3. Initial flow rates for shale gas are impressively high (anecdotal)
4. Depletion in shale wells is very high, particularly in the first few months of operation (Also anecdotal)

Figure 2

The only two years in the past decade when production per well increased were 1999 and 2007. These years featured relatively low prices in natural gas, so the increase in per well production may be due to producers:
1. Only drilling their best prospects that year
2. Reducing the number of existing wells since the low price did not justify the existence of marginal wells.
It is also clear that 1998-1999 represented a turning point in the production per well. This could be due to a number of different factors:
1. A decrease in the quality of available resource
2. A shift in the type of well being drilled (conventional versus unconventional)
3. An increase in the rate of drilling after 1999. Starting in 1999, there was an explosion in the rig count and the number of new wells drilled. The acceleration of drilling would more quickly change the demographic of total wells toward lesser quality or unconventional wells.
This is consistent with data on the number of operating drill rigs. Glancing at a graph of drill rigs, it is clear that there was a noticeable increase in rigs starting in 1999 (Figure 3).
Figure 3 (Source: Baker Hughes)

While supply stayed more or less constant from 1998, the number of existing wells increased dramatically, and the rig count exploded. This trend continued through 2007 when shale natural gas wells started changing the dynamics of the market.
Take a close look at Figure 3 and you will see that there have been 3 dramatic falls in rig counts in the past ten years: 1997-1999, 2001-2002, and 2008-current. These drops in drilling activity correspond to very low prices for natural gas (as the famous quip goes: low prices are the cure for low prices). In section 5 the rig drops in 1998 and 2001 are examined and used to model what might be expected in 2009. Speaking generally, as drilling activity slows, there is a point at which depletion of the total existing supply exceeds new marginal supply, and total supply starts to fall. Because the rig count falls below the maintenance level, supply continues to fall even after the rig count starts to climb. This is because it takes a period of time to activate the number of rigs necessary just to drill at the level necessary to maintain supply. In Figure 4, there is a graphical estimation to prove the point.

Figure 4 Rig count starts at exactly the level necessary to maintain supply. We assume an annual depletion rate of 25% and also assume a 40% decline in drill rigs from peak to trough that declines linearly over a period of 40 weeks. Finally we assume that once the rig count has bottomed, the rig count then has a linear increase back to the initial rig level in 25 weeks.

This figure gives a first approximation for how supply responds to decreased rig counts. In order to try to model the 2006-2009 period a little bit more accurately, some assumptions need to be made. First, it is pretty clear that we were expanding supply from 2006-2008 at a meaningful (some would say blistering) pace. Therefore, the drill level was above the level necessary to maintain supply, and this is confirmed by the increase in supply during 2008. Furthermore, the increase in rigs during this time period was particularly marked for horizontal rigs in shale deposits (footnote 5:The emergence of horizontal drilling for shale natural gas is probably the most significant development in the energy sector over the past 3 decades. Some market participants have noted the extremely fast depletion rates of shale natural gas wells. While a fast depletion rate will present a challenge after the supply of shale gas peaks, it actually makes the resource more flexible and responsive so long as the resource is increasing. While this paper generally holds the view that natural gas prices could spike in the next 12 months, shale natural gas and its high depletion rate will actually act as a damper on this price increase. Since initial flow rates are so high and a larger percentage of a shale well’s production occurs in the first few months, this decreases the amount of time necessary to increase supply by significant quantities) : the number of these rigs expanded by more than 100%. When the total number of drill rigs peaked in late 2008, producers could very well have been drilling 50% more wells then was necessary to maintain then-current levels of supply. That will be the baseline assumption in the estimate that follows.(footnote 6:Other assumptions include: horizontal rigs are modeled to drill twice as much gas per rig as other types of rigs to reflect the elevated initial flow rate of shale gas. Depletion rates are assumed: horizontal wells deplete at 70-80% per annum, and other wells deplete at 40-50% per annum. I am not suggesting that Figure 5 is a completely accurate depiction of reality; for one thing, it does not account for supply that was lost during Hurricanes Katrina, Rita, Gustav, and Ike. It also aggregates different types of wells, and makes assumptions about depletion rates that may or may not be accurate. But it will give a better broad view of supply then what is suggested in Figure 4. The red curve at the end of the graph reflects an estimate of what future supply would look like if rig counts started increasing next week and increased linearly at a rate of 30 rigs a week.)
Figure 5 Rig Data from Baker Hughes. Curve depends on depletion rates estimated by author

This figure is meant to illustrate the concept that supply will continue to fall even after rig counts start to recover. This is because we have now overshot the number of rigs necessary to maintain supply, and so supply will fall until we return to that number of rigs.
In conclusion, by comparing to past instances where rig counts fell below the level necessary to maintain supply, we can expect that supply will continue to fall for at least another month or two. If rig counts stay at current levels (or continue to fall) then the nadir in supply will be pushed out that much further. To relate this back to section 2, an expected reduction in supply would cause, everything else equal, the second derivative of natural gas storage (that is, the change in the flow rate) to be negative

4. Demand

Evidence is starting to accumulate that production of goods is stabilizing. Consumption data also appears to have stabilized. According to the most recent Census report, sales did not drop between March and May. While inventories are still dropping, the underlying production levels seem to have stopped declining, and are at a level slightly below consumption levels. Again we are faced with a stock versus flow situation. The stock of goods is too high, but the flow is now negative (that is, the production of goods is lower than consumption of goods.) Unless consumption drops further, we can expect production to come up at least to the level of current sales. This point is fleshed out with a particular focus on natural gas by an investor and trader named Rob and with a tag of Robry825. For those interested in looking in more detail at the demand for natural gas, I recommend reading his weekly blog post at http://robry825.blogspot.com, and also his near-daily postings at the Investor Village CWEI message board :(http://www.investorvillage.com/smbd.asp?mb=2234&pt=m&clear=1) for detailed and disaggregated data on demand for natural gas.
A quick comment on weather: one of the big stories in the natural gas market this summer has been the bearish weather. With the exception of several weeks of hot weather in Texas, this summer has been remarkably cool, and there has not even been the threat of tropical storms in the Gulf of Mexico. As of mid-July, we have predictions of continued unseasonably cool weather across most of the CONUS. The psychological effect of weeks and weeks of cool weather may be leading market participants to overemphasize the importance of bearish weather. Weather forecasts are only accurate to 14 days, so we could very easily have a bullish switch in weather, such as a hot August or a cool October.
In conclusion, I think that the demand side for natural gas is uncertain. There exists the possibility that goods consumption and natural gas demand will fall still further, particularly if our fate is to plunge into a deflationary depression. Barring such a worse-case scenario however, we might expect industrial demand to pick up soon, since current industrial production is below current consumption levels. This again points to a flat or negative second derivative for natural gas storage levels.