Natural Gas Undervalued at Present Levels?

In my June 1^st Energy Alert I said rarely are hedges more attractive than at present for the 4 following reasons:

1. Over 95% of the time since 2002 wholesale Natural Gas and Electricity rates have been higher than present levels.
2. Large commercial hedgers are holding large long positions.
3. Potential changing dynamics in production and consumption not fully factored into pricing.
4. Risk of warmer than normal summer weather or a Gulf storm hitting the Henry Hub in Louisiana, the delivery point for NYMEX Natural Gas.

As you can see in the chart below 95% of the time since 2002 Natural Gas has been higher than present levels:

Also, as of this week, large commercial hedgers continue to hold near record long (BUY) positions of Natural Gas, which historically has preceded short-covering rallies. Remember Commercial Hedgers are more highly capitalized than speculative traders and it is in their interest to move the market based on their capitalization.

But in this report, I will focus on the potential changing dynamics in production and consumption not being fully factored into pricing. As I stated in my June 1^st Energy Alert the EIA released its monthly Natural Gas report after the close on Friday May 29^th. In this report the EIA revised down its first quarter estimate for dry Natural Gas production and revised up its estimate for Natural Gas consumption.

This was important information because based on previous EIA reports market participants believed Natural Gas production would steadily increase in 2015. But the EIA revision revealed production actually declined. In the fourth quarter of 2014 Natural Gas averaged 73.3 Bcf/d, and after the revision we now know production in the first quarter of 2015 averaged 72 Bcf/d.

Why were previous estimates falsely reporting increased production and decreased consumption?

The answer can be found by understanding the EIA’s Natural Gas production data has a 2 month lag; therefore, the closely watched EIA weekly Natural Gas storage reports tend to be inaccurate during transitional periods, and we may be in the early stages of a transitional period of decreasing production and increasing demand.

To understand why this may be happening we need to determine the primary factors contributing to decreased production and increased consumption of Natural Gas in the 1^st quarter of 2015, and most importantly the probability these factors will continue?

Below I summarized the primary factors contributing to decreased production and increased demand in the 1^st quarter and why this trend will likely continue:

1. Crude Oil prices collapsed in the fall of 2014 falling from more than $100 per barrel to under $50 per barrel within 6 months, and the Crude Oil rig count not surprisingly also collapsed, declining from 1536 to 642 oil rigs. This is important because as much as 1/3rd of new natural gas production is from oil rigs, known as associated gas. The effects of the decline in oil rigs is now just beginning to be reflected in the EIA Natural Gas production numbers.

2. Crude Oil has strengthen a little and is now trading near $60 per barrel, but on Friday, OPEC agreed to stick by its policy of unconstrained output for another six months ignoring warnings of a second leg lower in prices as some members such as Iran look to increase exports. There is no reason to believe Crude Oil prices will increase based on current levels of Crude Oil production; therefore, the Crude Oil rig count will likely remain low for the foreseeable future, and production of associated gas will continue to be adversely affected.

3. The low price of Natural Gas and increased federal regulations for Coal is forcing closure of Coal fired power plants, which are switching to Natural Gas. It is anticipated 4.4 GW of coal power plant power generation across the northeast will be retired during the month of June. This lost generation will likely be picked up by Natural Gas, which would add .4 BCF/day of new demand for Natural Gas. Projections for further Coal fired power plant closings is anticipated in the second half of 2015 and 2016.

4. Also it has been reported three Midwestern nuclear power plants may be retired later this year due to a lack of taxpayer support. These three plants have a combined capacity of over 5.5 GW. If they close, natural gas demand could increase an additional .5 BCF/day. We will continue to monitor developments for these power plants and give you further updates in future reports.

5. Growth in Natural Gas exports to Mexico is expected to continue due to their growing need for electricity as their economy grows. This growth alone could be a game changer adding as much as 3.2 BCF/day additional demand for Natural Gas as reported by Platts’ Bentek Energy, a respected energy analytics company.

Other factors will affect Natural Gas demand this year, and none is more important than the weather, which can have a profound effect on demand and the price of Natural Gas. But based the factors listed above, Natural Gas prices appear to be undervalued at present levels and considering Natural Gas has been higher 95% of the time since 2002, we recommend obtaining fixed rate hedges at this time.

Not every client’s risk tolerance and hedging strategy is the same, but we trust the above report will help you put into perspective the risk/reward opportunities at this time. I invite you to call one of our energy analysts to help you plan a hedging strategy appropriate for your situation.

Ray Franklin
Senior Commodity Analyst