by Robert Rapier, Investing Daily
Investing Daily Article of the Week
Over the past decade, the emergence of shale gas has turned the United States into the world’s leading natural gas superpower. But supply imbalances linger, which creates disconnects between the perceived and actual value of certain natural gas investments. I’ll explain why that’s good news for investors who seek value plays in the overbought broader stock market.
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It’s easy to forget the outlook for the U.S. natural gas markets circa 2005. Natural gas production had begun to decline. Natural gas spot prices regularly spiked above $10 per million British thermal units (MMBtu), and sometimes as high as $15/MMBtu.
The late investment banker Matt Simmons predicted in 2003 that with “certainty,” by 2005 the U.S. would undergo a long-term natural gas crisis for which the only solution was “to pray.” T. Boone Pickens and a number of high-profile energy insiders concurred.
ConocoPhillips (NYSE: COP) and ExxonMobil (NYSE: XOM) made large acquisitions of natural gas companies, betting on a future with much higher natural gas prices. Liquefied natural gas (LNG) import terminals were built to help address the expected supply shortfall.
Shale Gas Saves The Day
The crisis didn’t happen. Natural gas production rose sharply as a result of advances in hydraulic fracturing and horizontal drilling, and that kept prices under control. Natural gas spot prices fell below $10/MMBtu in 2008, and since 2010 have rarely been above $5/MMBtu.
There have been two exceptions since then. During the winter of 2014, low natural gas inventories caused spot prices to briefly spike above $8/MMBtu. This happened again during the first week of 2018, when low inventories caused prices to briefly spike above $6/MMBtu. I’ve circled this time period in the graphic below:
Natural gas consumption in the U.S. is highly seasonal, so producers use underground pressurized storage that builds inventories from spring until mid-fall. During the winter heating season natural gas demand spikes and this storage is depleted.
Inventories Impact Price
In the case of a mild winter as in 2012, inventories may not be significantly depleted before they begin to rebuild. In fact, the winter of 2011-2012 failed to pull gas inventories below 2 trillion cubic feet (Tcf) for the first time in over 20 years. Inventories in 2012 bottomed out in early March above 2 Tcf, which was also two to four weeks earlier than is typical.
Note how these storage levels correlate with natural gas prices. Following the warm winter in 2012, natural gas spot prices bottomed out a month later at under $2 per million Btu (MMBtu), and they didn’t recover back to the $4/MMBtu level for a full year. But then following the winter of 2014, when inventories ultimately fell to their lowest levels in a decade, natural gas prices spiked briefly above $8/MMBtu, and spent most of 2014 above $4/MMBtu.
Now, notice the current status of natural gas inventories as we head toward the high-demand season (which begins about November 1 each year). Seasonal inventories are at the bottom range of the five-year average, and last week they broke slightly below this range. And since U.S. demand has increased by about 8% in the past five years, the current inventory on hand will cover fewer days of demand than it would have at the same point five years ago.
Disconnect Equals Opportunity
Yet natural gas prices do not reflect an elevated supply risk. Natural gas for January and February 2019 delivery are priced barely above $3/MMBtu. Should that supply risk materialize, natural gas prices in late winter will certainly go much higher than $3/MMBtu.
These are the kinds of opportunities that should catch the attention of investors. The share prices of major natural gas producers like EQT (NYSE: EQT) and Cabot Oil and Gas (NYSE: COG) have been in the doldrums due to natural gas prices that have struggled to break out of the $2.50-$3.00/MMBtu trading range. If prices do break above this level – and the probability of that is increasing – then that could be the catalyst for these companies to move higher.
Natural gas is currently priced for perfection, with the implicit assumption that production will pick back up enough to prevent supply concerns. There are many risks to this perfection scenario (a cold winter, hiccups in production, increased exports to Mexico) that in my opinion are not sufficiently priced into the market.
