The Bull Case for Natural Gas – prices will increase as natural gas emerges as greener fuel alternative

With natural gas prices under pressure there is a lot of chatter about when prices will rise again. There is no shortage of bearish news with many suggesting natural gas is going to $1.oo/unit or that there is really no floor in sight. More bullish view is that prices will bottom in the coming weeks as hedges expire and production cuts start to take full effect. But there is more to consider with natural gas over the long term.

For investors we all know prices go up and they go down. JP Morgan was once asked what the market will do… he replied “It will fluctuate”. The important part is “when?”. The timing of when prices will trend in a certain direction is what everyone wants to know but no one can answer with complete certainty what day that will occur. And just because a commodity hits bottom does not guarantee that it will go up. However, within the next few months there are conditions that suggest natural gas  prices will trend up, and today’s new lows (which may go lower before going higher but it seems to be firming up now) may present some attractive opportunities for long term investors.

The bull case of natural gas is not made over the immediate term. There is still a possibility we will see lower prices between now and November as US inventories approach storage capacity limits. Tomorrow another supply increase from the EIA will add to this speculation. The bull case presented here is for the longer term with some estimates of when one might start to see the early indications of a turn-around in the price of natural gas.

The price theory is usually based on two simple components – supply and demand. A change in supply or demand will impact – change – the price. Or as is sometimes the case – like with natural gas – a change in supply and demand impact the price. The economic downturn diminished the demand for natural gas. At the same time, energy companies tapped new discoveries of shale gas that increased the supply of natural gas on the market (for a given amount of time). The estimated natural gas reserves have now been increased by ~39% while US inventories are nearing their physical storage limitations. Supply went up, demand went down and along with it the price – falling from a peak of $14.00.

The “Bear” view on natural gas prices is that demand will continue to be anemic, and supplies will remain high which will lead to a long term flat price. The detailed talking points are:

• Demand destruction – industrial demand is soft due to suppressed economic conditions. US consumption is down ~36% from 2.7 trillion cubic feet in January, to 2.1 trillion in March, to 1.7 trillion cubic feet in April.
• Increased supply from shale gas – natural gas reserves are up by as much as 39% due to shale gas. To British Columbia’s Horn River basin, Exxon Mobil (NYSE:XOM) suggests that its first four wells will produce between 16 to 18 million cubic feet of gas per day which is nearly 5 times the flow rate of a typical well in Texas’ Barnett shale.
• Moderate summer weather – it has been a moderate summer in areas of North America that would normally have their gas powered air conditioners on full blast to stay comfortable in the office and at home. And one might suspect that a cooler weather pattern in the east and south east may tame the coming hurricane season.

So… low demand + high supply = low price. Makes sense if you are focused on the daily spot prices on natural gas. But the assumptions being made are that things will stay the same. Demand will stay low, supply will stay high and perhaps most importantly the utility of natural gas will not change.  Conclusion – prices will continue to stay low.

Over the next couple weeks, natural gas prices could go down further from their current lows – especially if inventories push up against physical storage limitations. If storage limitations are reached, prices will come off more and may force natural gas producers to cut production back more. At the current rate, if US natural gas inventories continue to increase by 65Bcf per week it will reach its storage capacity of 4 trillion cubic feet in late October or early November. However, if additional cuts occur there is a real risk of a potential spike in future natural gas prices. Shut in production is going to be big and has not yet come down stream. But what are the chances of that occurring?

Well, as stated it could very well occur if the current weekly deliveries continue adding 65 Bcf to US supply inventories. However, what is interested to note here is that this is the same time frame that production cuts are expected to take effect. More about why production cuts will star to take effect over this time in a minute.

Now let’s look at the complete definition… “Supply and demand” is an economic model based on price, utility and quantity (supply) in the market. In economics, utility is a measure of the relative satisfaction from, or desirability of, consumption of various goods and services. When analyzing commodity prices we will certainly hear references to supply and demand but rarely hear about utility. That’s because commodities are comparatively constant and their market prices trade based primarily on “supply and demand”.

Thanks to new technology and methods in horizontal drilling and fracturing which make “shale gas” economically feasible, natural gas has realized a dramatic change in its estimated reserves in North America which have changed the fundamental utility of natural gas itself. Only two years ago, natural gas was lumped in with oil and was viewed as a resource that had reached peek production and was in decline. Today, it is now viewed as a long term energy resource that could potentially power North America for the next 30 years – perhaps longer depending on who you read. Reserve estimates in the US are up ~39%. What is apparent is that shale gas has completely changed how we view natural gas as a long term energy resource and how it will play an increased role in North America’s energy mix.

The base analysis on the price of natural gas is weather. Natural gas is still a domestic commodity as opposed to oil which is an international product. Oil prices are dependent on many factors while natural gas has historically been tied to weather. Traditional consumption of natural gas is higher in summer – when air conditioners are humming; and winter – when we are heating our homes. During the “shoulder season” – Spring and Autumn – storage goes up in preparation for the coming seasonal demands of summer and winter. As we approach Winter 2009, demand and consumption will begin to draw on the inventory supply. Current predictions are that Winter 2009 will be moderate. The other weather factor is hurricane season which has not been a concern so far. We all know the effects of hurricanes when they take out or cause shut downs in the Gulf area.

The next part of a base analysis is whether one believes the economy is going to recover. In other words, if the economy improves so will industrial demand for natural gas and so will the price. The demand was diminished by a recession at the same time supplies increased. We actually experienced a normal cycle of events that was magnified with the “great recession” and massive new gas discoveries. An increased supply potential from shale gas would certainly impede an appreciation in natural gas prices brought about by improved economic activity especially when the projected recovery is expected to be so mild. Sounds reasonable, but again production is expected to go down -not up – as cuts are expected to take effect in the coming weeks. Why have they not taken effect yet?

Production cuts have not yet taken full effect mainly because many major producers have hedged a large portion of their production through to the end of October 2009. Once the hedges expire shut-ins will have immediate impact on the weekly deliveries right at the same time that people are starting to turn up their thermostats to keep warm during cooler autumn and winter nights.

According to the Energy Information Association, the US imported ~4.o Trillion cubic feet (Tcf) of natural gas in 2008 with nearly 90% of these imports coming from Canada. In Canada, that vast majority of natural gas production comes from “conventional” drilling in the Western Canadian Sedimentary Basin (“WCSB”). Approximately 42%, or 7.4 billion cubic feet per day (Bcf) is consumed domestically, and the 58% surplus or 10.4 Bcf per day are exported to the US. Last year in Canada, there were ~21,000 drilled, and this year there will be ~9,000. Last year 32,000 wells were drilled in the US. This year there will be less then 15,000. The point here is that filling historical demand for natural gas has traditionally depended on ongoing drilling and production. Big production cuts will have a big impact on natural gas supplies, and these cuts are coming as hedges expire.

We have stated many times before  - supply inventories will always fall faster then demand. Weekly deliveries must be equal to consumption. If it is not, then you are drawing on supply inventories, and these inventories start to decline. Certainly natural gas consumption is down, but it is not down by 50% and it will go up (little or a lot) when winter starts. A normal winter season will draw down currently high natural gas supplies substantially.  It is going to be very interesting to see if expiring hedges and production cuts take hold before natural gas hits its physical storage limitations in the next few weeks.

Another interesting trend to note is the price disconnect between the price of oil and the price of natural gas is not sustainable. In the oil and gas industry the pricing between natural gas and oil is based on an energy equivalent. In other words, how much natural gas does it take to generate the same amount of energy as a barrel of oil. The price ratio that is used is 6 to1, because it takes 6,000 cubic feet natural gas to generate the energy equivalent of one barrel of oil. Natural gas prices are now trading at roughly an 80% discount to oil on an energy equivalent basis, which is well below historical levels. So on this matrix natural gas would have to increase in price or oil decrease or a combination of both. Either way it would appear that this pricing model would support an increase in natural gas prices once the inventory fears have dissipated. The markets will work it all out.

The largest long term impact will be natural gas emerging as a “greener” energy alternative and secure domestic resource in the US. Remember the reserve increase of natural gas due primarily to shale discoveries has changed the utility of natural gas. The fact is that green energy demand is here to stay.  Governments and consumers worldwide are under increasing pressures to reduce carbon emissions. Natural gas is the cleanest burning fossil fuel spewing 50% less carbon then coal and about 30% less then oil. It is a proven resource that presents the most practical solution for reducing carbon emissions substantially in a very short order comparative to other options. It will have immediate and substantial effect if usage is increased considerably in power generation and transportation. It is not the perfect solution, it does emit carbon and it is not renewable but a real reduction by using more natural gas in our energy mix is a step in the right direction.

In the US, the argument for natural gas goes further as it is being sold by T Boone Pickens et al as a big part of the US getting off of foreign oil and using their own domestic resources to provide power. This includes natural gas, and every other renewable energy source available. As the largest consumer of oil in the world (for now) the US is transferring money out of their economy to “unfriendly” countries that use this money against US interests. (Canada is a “friendly country”… Mexico is neutral… then all the rest). Energy is strategic. Using domestic resources to meet energy demand and reduce carbon emissions makes logical sense. Natural gas’ strategic value in North America is going up.

Regardless of when the economy begins to recovery, there is a growing momentum that natural gas may be playing a bigger role in US energy policy then it had before its price crash and economic downturn. As explained, the new found abundance of natural gas due to shale gas feasibility has made natural gas the front runner in US policy for reducing carbon emissions. Like always, US politics must give attention to all interests including oil and coal so any changes to current policy will be worded very carefully as to minimize political back lash. But in the end, natural gas still represents the most practical resource for meeting carbon emission goals immediately. Supporters are working hard to partner natural gas with other renewable sources like solar and wind to offer a compelling argument for using natural gas more in areas where oil and coal are used (as always… lets remember we can not replace oil and gas completely. But we can use more of natural gas which emits 50% less carbon then any coal, or so called clean coal technology today).

There will be challenges here. The coal lobbyists are not eager to give up any market share to the natural gas industry and have spent millions of dollars increasing market share in the US through a very powerful lobby group. They will argue that natural gas is risky due to volatile prices. They will be quick to remind law makers of past price spikes brought about by past hurricanes. Furthermore they will argue that “clean coal” technology is very close to being realized and will ultimately make coal a cleaner option then natural gas with a stable low price even after the costs of implementing carbon capture solutions.

New demand for natural gas will not happen immediately, and will occur overtime. New natural gas fired electric plants take time to convert and build. Industry is slow to convert unless they see a stable prices. Upcoming production cuts will be a catalyst to increased prices, and if cuts are too deep they may result in an unexpected price spike. Any price spike that may occur will add volatility to the price and may further defer industry conversions.

So, the bull view goes something like this… supplies will drop due to production cuts, and demand – albeit moderate – will increase due to cooler weather and improved economic conditions. Lower supply + higher demand = price appreciation. The detailed talking points are:

• Supply destruction – The majority of natural gas producers have shut in as much as 50% of their natural gas production and this has yet to fully impact downstream inventory supplies. Readers here are well aware of the fact that supplies will fall faster then demand. Meaning if you don’t fill the supply tank up equal or greater then the rate you are sucking it out, the amount in the tank will diminish. So while shale gas has added supply, the overall supply coming down stream has yet to fully reflect the production cuts being made.
• Shale gas – shale gas has absolutely increased the potential reserves across North America. There is a tremendous amount of shale gas locked in the ground. It is easy to be fooled into a bearish position (there is too much supply) when companies start reporting wells that are producing 20 million cubic feet of natural gas per day. Shale gas flow rates deplete quite rapidly. Meaning they come on producing at high rates and drop off significantly in the first 6 and 12 months. Therefore, a well that may produce 20 million cubic feet initially may produce half that amount 12 months down the road. Furthermore, though shale gas projects post big numbers the “recoverable” amount of gas is usually 30-40% (or less) of the total reserves.
• Demand construction – If the “demand destruction” contributed to a decline in natural gas, demand construction will result from cooler weather and a turn-around in the economy. Now we all know that the economy is not going to come back to what it was before the economic collapse. But the economy improve and natural gas demand will increase.
• Demand for Green Energy – The demand for “green energy” is here to stay creating “new” demand for natural gas. In case you missed it, we are destroying the environment by spewing massive amounts of carbon into our atmosphere. We need cleaner, affordable, reliable and abundant/renewable sources of energy. Sound familiar? Natural gas. It is the cleanest fossil fuel; it is affordable (its not $14 and it is even affordable at $7); its reliable (does not rely on the sun, or the wind but we need them too) and it is abundant (we know there is as much as 39% more natural gas reserves in the US then there was before shale gas was feasible).

And once this new demand comes along, there will be plenty of opportunity to increase supply from areas like the Horn River basin to meet new demand and tap into those reserves. Exploration and production will increase and the cycle will begin anew. Enough so that it is unlikely that we will ever see $15 natural gas within the next decade. But anything is possible given enough time.