Will Natural Gas Hit $1?

This was submitted by Lior Cohen, M.A. at Trading NRG using the Trefis Contributor Tool

Natural gas prices resumed their sharp decline during last week. Will this freefall continue? Here is a fundamental analysis by Market analyst Itai Furman.

The slide in NG prices is primary a result of technology improvement, mainly the ability to dig horizontally that practically gave US ample supply for the next 100 year. Never the less, the last 6 month drop is impressive and seems to be more than just the long term bearish fundamentals.

The complete natural gas market analysis at Trading NRG

The current problem in Gas market is the collapse of demand, but the major medium term threat is that gas storage will hit its limit capacity of around 4,100 Billion cubic feet. NG is a cyclical commodity. In the winter the storages are depleted and in the summer they are rebuild. The rate of formation is quite constant with slight increase YoY. In 2008 the formation reached 2,195, in 2009 it was 2,180, in 2010 it hit 2,225 and in 2011 summer around 2,275 billion cubic feet were formed. 2012 build up will probably be around 2,300 or so.

If we subtract this build-up from the maximum capacity we reach our “magic number” for the current winter – 1,800. If by March total gas in storage will be above this number, expected build-up will probably breach the maximum storage capacity. So, the million $ question is, will we reach it?

If the current depletion rate will remain for the rest of the winter, storage level will bottom down at 2,500, well over our magic number and a level that will result in a capacity breach. But, it is unlikely to believe that the winter will remain that warm. If weather will return to “normal” and the usual draw will return, we will reach 2,300, still way too high. Actually, in order to reach our 1,800 target or even to get close to it, the winter should be very, very cold and it has only 2 months to do that. This is a very unlikely scenario.

As hard as it to believe it, Natural gas can hit $1. Actually unless temperature will drop considerably, by March we will probably be well above 2,000 billion cubic feet in storage, and when the build-up will start, every one will do 1+1 and will reach the conclusion that current prices are too high. Probably, the short term contracts will be massively dumped and the price can drop well below $2 toward the $1 mark or even lower if speculative selling will occur.

Under these circumstances, a straight short seems a reasonable strategy (short UNG), but a better one might be to short the April-November contracts, hoping the capacity breach will send short term gas prices toward $1, and go long on the December 2012 – March 2013 (The “winter” contracts) ones where prices should recover as demand increases. Naturally, the market is quite smart and the contango increased considerably, probably as hedge funds followed the same logic and position them-selves accordingly. Current short contracts are trading in $2.7-$3 and the summer contracts are trading around 3.7$, but this seems a little price to pay.

The writer is currently holding a short position in the US natural gas market

For further reading:

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