Natural Gas Market Dynamics Suggest Price Rebound

The price of natural gas continues to slide downwards as production remains high and consumers benefit from mild weather, reducing their need for the fuel. This continuing trend would appear unfavorable for many of the natural gas companies, including Chesapeake Energy Corporation (Ticker CHK) and EnCana Corporation (Ticker ECA). Indeed, the stock prices of these companies have continued to slide over the past month as investors worry about the financial impact.

Furthermore, a recent article in the Wall Street Journal highlights that storage for natural gas is expected to reach capacity before the end of the year if production does not slow down and the weather remains mild. This highlights that the price of natural gas in the US is determined more on short-term supply-demand trends due to an inability to store large amounts of the gas. It also highlights that something has to give because companies likely won't simply blow the excess into the atmosphere, accept negative prices, or some other crazy market scenario. Under my Sagflation theme, I expect more volatile prices, especially for commodities, and thus a strong rebound in natural gas prices would not be surprising, in my view.

Investing in a company that produces natural gas would seem foolhardy with the price of natural gas around $2, the lowest in about 10 years, and supply apparently continuing to outpace demand. But, there are signs that drilling is slowing and demand may pick-up. With limited storage capacity, making prices more volatile, this shift in supply-demand potentially precedes a turn-around in natural gas prices later in 2012 and 2013. For these reasons I have begun to build long positions in natural gas companies, initially a small position in EnCana Corp. with a 4% dividend yield.

Let's go through some market dynamics of natural gas:

(1) Demand likely increasing
There are four basic domestic users of natural gas, which are (1) Homes for heating, hot water, appliances, (2) Businesses for heating, hot water, appliances, (3) Commercial for manufacturing, and (4) Electricity production. The only one of these four segments that has grown over the past decade is electricity production. The first two segments have remained relatively flat due to improved efficiency through better furnaces and insulation. Industrial demand has slid, most likely due to the shift of manufacturing overseas.

An increasing number of electric power plants may shift to natural gas as an alternative to coal as the price for natural gas falls. Energy analysts at Sanford Bernstein estimate that electric utilities may increase consumption of natural gas by 13.5% in 2012 as they switch from coal. This is likely driven by the falling price of natural gas. As discussed on the Wall Street Journal, the market is already pushing electricity producers towards building additional gas-fired plants. But, referring back to the fact that natural gas prices are set more based on short-term market dynamics than long-term, there is greater risk relying solely on gas-fired plants because prices may increase dramatically in the future.

Furthermore, if a recent ruling by the EPA stands-up, then more utilities may be forced to shift to natural gas as a greater amount of the externality costs associated with the use of coal, and its larger release of carbon dioxide, are captured in the price of electricity. However, I believe this ruling is unlikely to stand-up to scrutiny by Congress given the outrage from the coal producers.

Another potentially major driver of demand in the near-term is increased exporting of the fuel as more ports come on-line with the ability to export the fuel. To export natural gas is to invite political scrutiny, and some debate about the advantages and disadvantages of creating a world market for natural gas. However, producers likely push hard to open up new markets that are willing to pay three to four times the price in the US. Simple market dynamics suggests that if the US does begin exporting natural gas, and thus creating more of a world market, the relatively low prices in the US likely rise and the relatively higher prices in Asia likely decline.

Longer-term an increasing number of industries may begin relying more heavily on natural gas, should manufacturing in the US continue to pick-up. Additionally, a device that allows fueling of cars with natural gas from the home may eventually prove a major driver of natural gas demand. A stimulant to home refueling could be a tax incentive towards purchasing the home device.

(2) Drilling for dry natural gas slows
There are signs that drilling for natural gas has slowed. Baker Hughes recently announced the company expects lower operating profit in the first quarter due to rapid transition in drilling away from natural gas towards oil. Indeed, the rig count for natural gas has fallen to a ten-year low of 647, relative to the 2011 high of 936 and all-time high of 1,606 in 2008. With production down around 60% from the all-time high, and continuing to decline, I believe natural gas prices should turn around.

Chesapeake Energy Corp, the second largest producer of natural gas behind Exxon Mobil Corp, has allocated approximately 85% of capital expenditures in 2012 toward crude oil and liquid natural gas resources, up from 10% in 2009. Comstock Resources (Ticker CRK), with 85% of its reserves in natural gas, has shifted to oil production with 77% of its 2012 drilling budget devoted to oil production. Devon Energy Corporation (Ticker DVN), with about 60% of its reserves in dry natural gas, has cleared much of its rigs out of natural gas production sites and has said the company is not "investing in new wells in a $2 market."
 
While a significant amount of natural gas continues to be produced as a by-product of oil drilling, this highlights that the trend is downward in natural gas production. It also potentially creates excess supply in the NGL market and may ultimately result in a strong rebound in natural gas prices when demand picks up.