If you throw a frog into boiling water, the frog jumps right out. If you place a frog in a pot and boil the water slowly, the frog stays put, blind to the impending danger. I never want to meet the sadistic human who figured this out, but the analogy seems appropriate for natural gas bulls trapped in a lower for longer price environment.
From March 1st through mid July, the continental U.S. experienced incredibly bullish weather for nat gas consumption that defies historical statistics. Cold temps led to unprecedented April withdrawals shaving ~210 BCF from EIA storage vs. five-year average comps. The “April ice box” for the upper half of the country immediately turned into super hot South Central weather with Texas, Oklahoma and Louisiana on fire supporting demand in the critically important Henry Hub region. For new readers, natural gas pricing is determined at the Henry Hub in Louisiana which has been the largest and most important natural gas trading point for the past 40+ years.
Frac’ing flipped the natural gas universe upside down starting in 2008, and widespread efficiency advancements are allowing producers to increase output with lower capital spending than ever before. You can see this clearly in any long-term price chart plotting L48 gas production against Henry Hub spot. For some reason, the bull camp will turn to any alternative thesis to justify natty’s imminent return to higher pricing. The most popular consensus opinions at the moment are huge LNG export demand coming in 2019 along with marginal production cost being higher than ~$2.60. Following closely behind is the idea that pipeline limitations from the Permian will limit production growth. This one truly has me scratching my head. All three are wrong, and we’ll get into the reasons why in my next article.
Outside of a low probability, short-term winter weather event, $4+ pricing is not happening anytime soon. There’s simply too much natural gas in North America for $4 pricing to return unless we enter the next Ice Age and Canada stops selling gas to the L48.
After close to 5 months of bullish weather, longer-range forecasts turned neutral/bearish for the second half of July and beyond early this month. Prices barely made it above $3 at the height of the heat wave in late June, and quickly crumbled below $2.75 as traders were reminded weather can go both ways. The market is always sending signals to the open minded, and the fact prices couldn’t hold above $3 despite an unusually long stretch of bullish weather is the biggest bearish data point of all.
Here’s the CME price curve into early 2019:
Source: CME Futures website
The CME curve is telling you the market is not worried about the twin EIA storage deficit. This is not a surprise to anyone who read my April article “Losing My Religion” detailing the reasons why historical EIA storage averages are no longer the right way to forecast future price direction.
The old model was far away production fields in Texas and Louisiana feeding storage facilities in the Midwest, Mid-Atlantic and Northeast through narrow pipes. Storage was needed near the end markets to service local winter demand given the limited capacity of the long-haul pipes during peak cold weather. Gauging prices based on storage differentials made a lot of sense when the old model ruled the kingdom.
Frac’ing has consistently dismantled the old model for the past 10 years, and the Appalachian production miracle was a happy accident adding fuel to the fire. No one expected the world’s most prolific shale gas basin to be located next to some of the largest demand centers on the planet. The Midwest, Northeast and Mid-Atlantic regions are building out midstream capacity improvements to get low-cost Appalachian gas to these key markets. Perhaps we’ll finally see a new pipeline to NY/New England given the incredible benefits of having clean, domestically produced natural gas less than 200 miles away in Pennsylvania.
The new model is built on high capacity pipelines connecting Appalachian production centers to local distribution hubs given the close proximity to major markets. The collective huge production capacity of the EIA South Central region will be used to satisfy LNG export and Mexican demand increases. The Eagle Ford, Permian, Haynesville and Anadarko shales have higher combined dry gas output than Appalachia. Storage is not totally irrelevant, but as we discussed in “Losing My Religion”, historical EIA averages are the wrong metric to use with monster pipelines like Rover, Atlantic Sunrise, Nexus, MVP, Leach Express, etc. expanding outbound capacity in all directions. Yes, there will be delays and explosions and the occasional hiccup. Bigger picture, over the next 24 months, significant new midstream capacity increases will cement the pivotal roles of Appalachia and the South Central shales for the North American gas market.
Gas prices are likely to stay in the $2.55 to $2.95 trading range for the next two to three weeks until the market gets clarity on August/September weather. EIA’s year-over-year storage comparisons are weak through late October. Traders are playing it cautious given there are only 42 days until September 1st. With the end of summer staring directly at the market, traders will focus on weather as the major demand catalyst. Aggressive traders should consider DGAZ between $25 and $26 and UGAZ near $49-51 as prices fluctuate rapidly on weather expectations. It would take substantial bullish weather to prevent large September/October injections, and that will be a headwind for the market until we get to winter. On the flip side, significant bearish weather cannot be ruled out. If August weather fizzles and September is average, there will be a tsunami of physical gas in the market with substantial pipeline capacity scheduled to come online by November 15th. Traders should maintain a bearish outlook heading into the fall, but that doesn’t mean you ignore the occasional long opportunity.
Rigs, DUCs, WTI, and Midstream continue to be the dominant factors impacting the price curve. Specifically, I’m watching Appalachian DUC inventory and weekly production trends.
Thank you for reading and good luck with your trades. Looking forward to your comments and feedback. If you enjoyed this article, please click “Follow” under my profile.
Disclosure: I am/we are long AAPL, GOOG, LNG, FOX, FB, DIS, NFLX, MSFT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I frequently trade UGAZ/DGAZ and UWT/DWT. Active trades are posted in the comments under my latest article.