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Natural Gas Still Treading Water

(October 27, 2011)

Dear Subscribers and Readers,

One commodity that has not participated in the bull market over the last several years is U.S. natural gas priced at the Henry Hub in Louisiana.  This is not surprising, given the tremendous surge in U.S. shale production.  Over the last five years (to year-end 2010), U.S. natural gas production increased from 18.1 Tcf to 21.6 Tcf a year.  U.S. natural gas production this year is expected to increase by 6.7% to more than 23.0 Tcf!  Following is a chart showing U.S. daily natural gas production over the last several years (courtesy of Goldman Sachs):

Note that while natural gas spot prices have remained in a trading range over the last 18 months, the price of UNG—the natural gas ETF—has declined by over 40%, due to significant contango in the natural gas futures curve and the cost of rolling over the contracts every month (chart courtesy of

Note that the price of the November 2012 Henry Hub contract approximately 18% higher than the November 2011 contract.  All things equal (and assuming the contracts are rolled over just once to next year), UNG will decline by about 18% should spot prices remain the same 12 months from now.

More important, despite new EPA regulations (Cross-State Air Pollution Rule) that would encourage fuel-switching (from coal-fired to natural gas) for power generation next year of up to 2.7 Bcf/day, there is significant political “risk” to this bullish scenario for natural gas.  Specifically, there is a strong opposition from utilities and politicians in the affected states.  Moreover, the EIA currently expects natural gas production to grow by 1.4 Bcf/day (2.1%) next year, but evidence suggests otherwise, as the natural gas rig count has continued to increase (from this year's low of 866 on May 20th to 923 on September 30th), despite lower spot and futures prices—suggesting the 1.4 Bcf/day increase is too conservative.  In addition, natural gas inventories remain very high, and are expected to hit the peak of its five-year range by the end of the injection season (and stay at about 10% over its five-year range for most of 2012).

Finally, the technicals for natural gas still aren't bullish, as exemplified by the following weekly chart:

Chart Image

As shown in the above chart (note the blue circles), natural gas prices have typically rallied whenever the faster MA (12-week) crossed above the slower MA (26-week)—as shown in the lower panel (which shows the Moving-Average-Convergence-Divergence technical indicator).  The 12-week moving average for natural gas prices is still below the 26-week moving average.  Given the ongoing supply increase, record high inventories, and the lack of monetary stimulus for now, I expect natural gas prices to struggle for the rest of the year.  One thing is for sure: I would still not go long UNG anytime soon.

Signing off,

Henry To, CFA, CAIA

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