Running Low on Gas
Overview
I predicted higher natural gas prices this year, but the current picture with soaring gas prices isn’t exactly what I had in mind. As I indicated when I made my prediction, short-term weather events such as “an exceptionally cold winter” can override longer term market drivers. This winter has been called the coldest winter in more than 30 years, which is just the sort of short-term weather scenario that will trump the longer term factors like the completion of LNG export terminals or the phase-out of coal-fired power plants. I am bullish on gas producers because of the long-term drivers, but the severity of this winter is likely to bring them some benefits sooner than expected.
Today I want to discuss the developing natural gas picture, with a focus on the nature of natural gas storage, and how investors should react to the situation.
Natural Gas Versus Petroleum
Natural gas is unlike petroleum, as it isn’t (presently) as easy to export excess production. While there is a current ban on petroleum exports, the expansion of domestic crude production has still led to growing exports by way of finished products. That is the loophole that has resulted in an outlet for growing US crude oil production, but it benefits the refiners selling the finished products instead of the oil producers who are unable to sell their product on the global market. So refiners are importing less crude oil, displacing it with discounted and semi-stranded domestic crude oil production, and then exporting excess finished products.
The picture with natural gas is different. We do import some liquefied natural gas (LNG) and we get some gas via pipeline from Canada, but the US is mostly self-sufficient in natural gas. As gas production has grown, we have displaced some of those natural gas imports, but the US market has less capacity to absorb additional natural gas production than in the case of additional oil production. Natural gas consumption in the power sector has grown (mainly at the expense of coal), but that growth appears to be leveling off. In order to continue to grow gas production without depressing the price, LNG export terminals must come online (which is a long-term driver discussed in detail in Natural Gas Is Still a Steal).
But in addition to the long-term driver, a short-term driver of natural gas prices has developed.
Natural Gas Storage and Inventories
Natural gas consumption in the US is highly seasonal, so producers use a system of underground pressurized storage that builds inventories until mid-fall, which are then depleted through the winter. Natural gas can be stored in depleted oil or gas reservoirs, in natural aquifers, or in salt caverns.
Source: Energy Information Administration – The Basics of Underground Natural Gas Storage
Depleted reservoirs offer the cheapest storage and are the most widely dispersed option geographically. Salt caverns are more expensive, but have the advantage of being able to inject and withdraw gas at much higher rates.
There are nearly 400 active underground storage facilities in the lower 48 states. These facilities are owned by pipeline companies, local gas distribution companies, and independent storage service providers.
The US has a total of nearly 9 trillion cubic feet (tcf) of natural gas storage capacity, but only a fraction of that has ever been used. According to the Energy Information Administration (EIA), the highest storage on record was 3.9 tcf which was reached heading into the 2012-2013 winter season. Inventories will usually build to between 3 and 4 tcf by Nov. 1, before being pulled down to under 2 tcf by the end of winter. So a typical winter season will see just over 2 tcf pulled out of storage — an amount equivalent to about 10 percent of annual US natural gas production.
In the case of a mild winter as in 2012, inventories won’t be pulled down as much before they begin to rebuild. In fact, the winter of 2011-2012 failed to pull gas inventories below 2 tcf for the first time in over 20 years. Inventories in 2012 bottomed out in early March above 2 tcf, which was also two to four weeks earlier than is typical. It is perhaps unsurprising with this high level of inventory that natural gas prices bottomed out a month later at under $2 per million Btu (MMBtu), and they didn’t recover back to the $4/MMBtu level for a full year.
Source: US Energy Information Administration
The Present Picture
Thus, as we have seen in the past, what happens with natural gas inventories (likewise with crude oil or finished product inventories) can have a lingering impact on natural prices. Which brings us to the present winter.
If the term “polar vortex” wasn’t in your vocabulary before, it probably is now. As we gear up for Round 3 of this influx of the Arctic chill into the continental US, we do so with seriously depleted natural gas inventories. This season’s withdrawal marks the fastest inventory depletion on record during the winter months. We have already withdrawn 2.4 tcf — more than the average for most winters — and are still likely four to six weeks away from the bottom. If withdrawals continue at the recent pace, the inventory level would reach zero the week of March 28th, which is usually around the time inventories start to recover. Of course should that threaten to happen, prices will likely respond.
Regardless of what happens over the next six weeks, natural gas inventories are likely to bottom out at the lowest level on record. The current lowest inventory level on record took place on April 11, 2003 at 642 billion cubic feet (bcf). Note that on the following graphic, the first price spike above $10 corresponds to that 2002-2003 winter when inventories were pulled down to what is at present the all-time record low level. I think it’s highly likely that this year’s inventory ends up below the previous all-time record low level. The only question is whether we can expect further gas price spikes as inventories continue to fall.
Source: US Energy Information Administration
Natural gas in underground storage hasn’t dropped below 1 tcf since 2003, but the latest EIA report from Feb. 14 showed inventories at 1.4 tcf and falling at a weekly rate of 245 bcf per week (average rate of decline over the past month). At that rate, during the current week ending Feb. 28 we will go below 1 tcf of gas in underground storage, but the EIA won’t report that number until late next week. At that time, I expect this will garner some attention in the media since it hasn’t happened in over a decade.
Low storage reservoir pressures associated with national stockpiles below 1 tcf not only mean lower reserves but could severely hinder further withdrawals from storage.
Investing for Higher Prices
What does this mean for an investor? Historically, a significant deviation from the norm in inventories, up or down, affects natural gas prices for many months. That means that even this early in the year it is probably a safe bet to say my December prediction for a higher average Henry Hub spot natural gas price in 2014 than in 2013 will almost certainly prove to be correct. As the following graphic shows, we are heading into gas injection season with a serious deficit, and gas producers are going to have to produce at high rates over the next eight months to rebuild storage.
For investors, this means natural gas producers will likely report better year-over-year results during every quarter this year. Oil prices that have risen back above $100/bbl are an added bonus for drillers with substantial liquids production.
Chesapeake Energy (NYSE: CHK) has already had a nice 23 percent gain since we added it to the Aggressive portfolio last May, yet remains below our $28 Buy limit. I would still buy CHK at this level, as I think the company will have a good year. But other major natural gas producers may have more room to run. Recent Conservative Portfolio addition ConocoPhillips (NYSE: COP), and last fall’s Growth Portfolio addition Devon Energy (NYSE: DVN) — both of which I personally own — are two of the top 10 natural gas producers in the US, and both are recommended Buys at current prices.
Cabot Oil & Gas (NYSE: COG) may be an even better deal, as it pulled back recently when the company announced that output will be flat in the first half of 2014 vs a year-ago as it shifts to pad drilling with longer lead times. Even with flat production Cabot will fare better versus a year ago as a result of higher gas prices. The shift to pad drilling will reduce costs and raise production efficiency, but then you will have already missed your opportunity to buy Cabot on sale. The stock is down some 10 percent in the past month (COP is flat and DVN is up 7 percent), but I don’t believe it will be down for long. Patient investors have an opportunity here to buy a good company on sale, and with commodity prices in its favor. For more on Cabot, see the portfolio update at the bottom of The Energy Letter from Monday.
Aggressive investors looking to make a short-term bet on the possibility of sharply higher natural gas prices could look at one of the leveraged exchange traded funds (ETFs). VelocityShares 3X Long Natural Gas ETN (NYSE: UGAZ) provides 3 times the daily return of the S&P GSCI Natural Gas Index Excess Return, an index composed entirely of natural gas futures contracts. This should be considered a very risky investment — too risky for me personally — but it has risen 70 percent over the past three months as natural gas prices have climbed. Moves of 10 to 15 percent in a day in either direction are not uncommon. Just keep in mind that leveraged ETFs fare badly when the price action gets choppy, as it has of late for this commodity.
Conclusions
Occasionally a short-term event can have a lingering impact on the markets, and when investors recognize this early they have an advantage. History shows us what happens when natural gas inventories are pulled down this low. It takes months to recover, months during which prices usually remain elevated.
As I was researching this story, I ran across a quote in a news story this week from Teri Viswanath, director of commodities strategy at BNP Paribas SA in New York. He said “The market has sold off on the expectation that the worst is behind us. However, given cold conditions starting tomorrow through mid-March, we think this is a premature selloff. This is nothing more than institutional investors taking profits and liquidating their March contract as we approach expiry.” He also noted that “the fundamentals are still relatively constructive” for higher gas prices in coming months.
I think this is a perfect example of a disconnect between the market and the fundamentals. Investors have a chance to pick up some natural gas companies on sale as the market has failed to recognize what has happened historically in this situation. Of course markets can do anything, but history is on your side. Natural gas prices are very likely to remain above $4/MMBtu throughout the year, with a chance of spiking much higher on any market disruptions. The downside risk appears to be quite low.
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