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Natural Gas Still Not a Buy

(October 14, 2010)

Dear Subscribers and Readers,

The last time we discussed the topic of natural gas prices at length was nearly a year ago in our December 10, 2009 commentary (“A Word on Natural Gas”).  In that commentary, we stated:

Earlier in the year, we were looking and waiting for an opportunity to buy natural gas, given the decline in drilling rates and the production decline in traditional wells.  At the time, we did not anticipate the high productivity in shale gas wells.  In late August, we (finally) got bearish on natural gas, and specifically on the natural gas ETF (UNG).  At the time, it traded at $11.35, and has since declined to $9.11 a share.  All gas watchers are now focusing on the weekly natural gas storage report to be released today at 10:30am EST, as the US finally experienced a short burst of cold weather last week (if this does not result in a big storage withdrawal, then watch out below).  However, the fundamental problem of “too much gas” remains.  Even as drilling rates have declined, domestic storage levels and natural gas production remain stubbornly high.  At the same time, global LNG production continues to ramp up – suggesting that US natural gas imports could easily satisfy any “demand spikes” should US consumption recovers in the foreseeable future.

In addition, natural gas imports in 2008 as a percentage of U.S. consumption had declined to its lowest level since 1998—suggesting that any marginal increase in demand (as mentioned) could easily be satisfied through an increase in imports.  Interestingly (and ominously for the natural gas bulls), natural gas imports last year as a percentage of U.S. consumption declined again, as shown in the following chart:

Figure SR2. Net Imports as Percentage of Domestic Consumption, 1995 - 2009

Note that natural gas imports—at just 12% of U.S. consumption—is at its lowest level in at least 15 years.  This decline in natural gas imports isn't a surprise, given the glut in natural gas drilling, production, and storage levels.  According to Baker Hughes, the natural gas rig count increased from 712 on October 2, 2009, to 962 on October 1, 2010.  Moreover, there has been a growing share of horizontal drilling rigs in the lower-48 states—resulting in more efficient and increased production.  Furthermore, natural gas inventories are just slightly below last year's record-high levels, as shown in the following chart courtesy of the EIA:

Finally, NOAA is predicting a heating season that is 3% warmer than last year, and a December 2010 to February 2011 period that is 7.4% warmer than that of last year:

Bottom line: Despite an anticipated slowdown in new natural gas drilling, there is no shortage of domestic production.  In fact, a recent study by MIT concluded that 80 years of global natural gas consumption could be developed profitably at a natural gas price of US$4 or below.  Again, for subscribers who want to take advantage of a recovering US economy, buying UNG (especially given the significant contango and seasonal spreads) is not the way to go.  Since our December 10, 2009 commentary, the price of UNG has declined further—from $9.11 a share to $5.86 a share.  At this time, I do not see any long opportunities in UNG unless it declines another 20% or so, and only if it takes the back end of the natural gas futures curve along with it.  A milder winter, coupled with a rise in the U.S. Dollar Index, may do the trick.  For now, I want our subscribers to be mindful of UNG and other commodity ETFs in general.

Signing off,

Henry To, CFA

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