Time To Get Cautious On Natural Gas
Back in early June, I discussed my belief that natural gas was undervalued in a post titled Natural Gas Is A Buy. I highlighted that over the past 20 years, when natural gas prices have dropped below $2.50 per million British thermal units (MMBtu), the price proceeded to more than double within two years. I pointed out that we were experiencing only the 4th drop below $2.50 in the past 20 years:
Natural gas consumption in the U.S. is highly cyclical. Between April and November of each year, more natural gas is produced than consumed. Producers store the excess output underground in pressurized caverns and other repositories until mid-fall, when inventories typically peak, and are then depleted through the winter. The extent of inventory build across the summer and of the withdrawals over the winter strongly influences natural gas prices. Cold winters increase demand for natural gas, but so do hot summers (by increasing the need for air conditioning, which boosts natural gas demand by utilities).
We just concluded a hot summer across most of the U.S., and while natural gas inventories remained historically high due to continued strong output from shale gas production, the severe glut that looked possible in the spring failed to materialize over the summer. In addition, natural gas production growth has begun to stall in response to lower prices. As a result, natural gas prices that fell to $1.49/MMBtu in early March are now trading at $3.34/MMBtu. The VelocityShares 3x Long Natural Gas ETN, which I recommended to attendees at a conference in May, has more than doubled since. Many natural gas companies have rallied along with natural gas prices over the past six months.
While that momentum is likely to continue for a bit longer, today I want to highlight the risk that natural gas prices may be getting ahead of themselves . Again, over the short-term, natural gas prices are strongly influenced by the weather. If we have a cold winter, they will likely push higher. But if we have a mild or normal winter? Let’s check on natural gas inventories courtesy of the Energy Information Administration’s (EIA) weekly Natural Gas Storage Report:
Note that inventories are running on the high end of the 5-year average. Perhaps more importantly, the stored volume is slightly higher than it was a year ago as we headed into high demand season. What happened? A mild winter resulted in moderate natural gas demand, and because inventories were high prices were crushed.
I don’t know what the winter is going to be like, but I believe – considering the high inventory level – that anything other than a very cold winter could knock the legs out from under the natural gas rally we are currently experiencing . So investors are urged to keep an eye on inventories as winter progresses.
