Got Gold Report – Natural Gas Cheap Again

ATLANTA -- The natural gas producers in North America have done such a good job at telling us how plentiful the clean-burning resource is that NatGas has become one of the cheapest of energy sources around – again. We intend to focus on that exclusively in this one-time special report, but first here’s this week’s closing table:

The big news this week in the gold patch is that the largest of the largest gold futures hedgers and short sellers in New York were still “getting out of Dodge” as of Tuesday, March 30, according to the latest COT reports. The details of that gold short seller exodus can be found in the linked charts for gold below. We will undoubtedly have more about that in our next full Got Gold Report, but for now, we’ll take another look at what we think is an imbalance opportunity developing in natural gas, just as it did last year about this time.

Cooking With Gas

Even though there is not really all that much more NatGas in storage right now than there was this time last year, the price of natural gas, at near $4 per MMBtu, is cheap by historical standards. How cheap? Well, even though “natty” is within the extremely wide range of pricing as shown in the long-term NatGas chart below, we thought it might be interesting for our readers to see it compared to a suite of other commodities.

Here’s the NatGas story in pictures from Got Gold Report’s Comparisonville.

First, just the dollar price of NatGas over the past decade:



Notice that NatGas peaked in January around $6 per MMBtu and has since corrected about 62% of the Aug-Jan price increase. Fibonacci theory aficionados are many, and we probably don’t have to point out to our readers that 50% to 61.8% retraces are not only common, they are commonly traded.

Looking at that log-scale chart alone we can see that NatGas is near the lower end of the 10-year price range. However, that kind of view ignores what has happened with the dollar over the last decade.

What would a chart like that look like if we take out the logarithmic smoothing you ask? It looks a lot different, doesn’t it, see below.



When we give each dollar level equal weight on the value axis, it tends to do two things (at least). First, it tends to better define when the graph is approaching historic support in absolute dollar amounts, and second it tends to exaggerate previous extreme advances. Both can be valuable to a short or medium term trader from time to time.

We like things simple here at Got Gold Report. And what could be simpler than looking at the no-log chart above? Straight-away we can see that the natural gas market is getting pretty close to the low side again. We can also see that natural gas is “uncomfortable” above about $9, because whenever it gets up above there it tends to get back below that level pretty fast.

Just last year, with the world reeling from the 2008 collapse and a glut of natural gas, NatGas edged to a high $2 handle very briefly, but we think it was equally “uncomfortable” down there too. So, let’s say the broad trading range we can identify is something more like $3 to $7 – to be conservative.

NatGas actually traded below $2 a decade ago, but dollars certainly went a lot farther in 2001 than they do today and it sure didn’t stay down there very long.

With NatGas probing just under $4 last week, we are close enough to the bottom of the range to begin thinking about positioning again. But, aren’t we constantly hearing there are literally oceans of natural gas now compared to then? Hasn’t that become the popular view today?

Not a Natural Gas Glut, but Natural Gas is Priced for One

Well, actually, according to the U.S. Energy Information Agency (EIA), as of this past week (report for March 26) there was about 1.63 trillion cubic feet (tcf) in the various NatGas storage facilities in the lower 48 states. That compares to 1.65 tcf in storage for the same reporting week in 2009 or about 1% less gas in storage than then. (Incidentally analysts were looking for an injection into storage this past reporting week of 20 billion cubic feet (bcf), but the EIA reported a smaller injection of 12 bcf. )

There is currently about 10.8% more NatGas in storage today than the 5-year average (1.63 tcf vs 1.48 tcf), so there is more NatGas available, but that is hardly a glut of gas. With that in mind, how can we judge just how inexpensive NatGas is today?

All we want to accomplish with this Got Gold Report offering is to get an idea of just how inexpensive NatGas is or isn’t. To see perhaps if it has gotten “too cheap” again, and maybe if it’s time to begin positioning in vehicles that track it again, like we did successfully last year at this time.

Why don’t we start with the most obvious comparison and chart NatGas relative to West Texas Intermediate Crude Oil. See the chart just below.



According to that chart NatGas is once again exceedingly cheap relative to oil. Either oil has become too expensive, or NatGas has become too cheap. By itself that doesn’t mean oil can’t rise further or that NatGas can’t fall lower. They can and they might, but as of right now that chart is screaming that an imbalance in the market is currently underway.

We Bargain Vultures just love imbalances because they represent opportunity.

Comparisons of just one commodity to another can be helpful, but oil and NatGas are in the same basket, so to speak. In order to better understand relative price or value it helps to look at other commodities and benchmarks. So let’s do so right now.

Take, for instance, something we know well, like NatGas in terms of gold metal:



Yep, according to that comparison chart, either gold has become exceedingly expensive or NatGas has become very, very cheap, or both.

What about silver?





Sure enough, it’s the same story with silver. Remember these are very long-term charts. NatGas is nearly at the cheapest it has been relative to silver in 15 years.

How about copper?



Yes, relative to copper NatGas has gotten really cheap, hasn’t it? Or, has copper just gotten really expensive relative to natural gas?

Okay, by now we are becoming comfortable that NatGas really is cheap on a historic basis, so cheap in fact that it pegs some of our other comparisons. NatGas is dirt cheap by most any measuring stick one wants to use.

So one might think given the historically cheap price for the commodity that the companies that produce natty might be getting trounced these days, right?

Let’s compare the XNG index, which tracks a basket of natural gas producers to NatGas itself and see what it shows:



What’s this? The price of natural gas is filthy cheap and yet the companies that produce it are actually expensive relatively speaking? How can this be?

It is simple, really. The NatGas producers also produce oil, which is expensive relative to NatGas right now, so producers benefit from that. However, we still think the chart above is useful because it shows that the natural gas producers are priced near their all-time 2009 highs relative to the price of natural gas. We think that if fund and portfolio managers were convinced that natural gas was going to stay this low, it would start to show up in the producers in the form of lower, not higher relative prices for them.

Are the Fundamentals Really all that Bearish?

The producers are not discounting the currently low natural gas prices, so what is keeping the NatGas price so close to the basement?

Well, with the price of oil so dang high, there must be a bazillion rigs out there drilling for both oil and natural gas, right?

Unfortunately for NatGas bulls, the onshore rig rate has risen for 13 consecutive weeks and as of March 26 there were 941 rigs turning in the U.S. looking for more NatGas according to data supplied the EIA by Baker Hughes.

Certainly the analysts we affectionately call the “Big-Gass-Bears” who are often seen on the televised business cable channels (they know who they are) have been out in force just lately to hammer the point that the drilling rig rate is going up. If you watch the T.V. business channels you’ve seen them. The Negative Nancy’s of Natty have also been pounding the table with comical statements like, “We have so much natural gas right now we don’t know where to put it!”

We can’t hold it against the usual suspects that they are consistently net short NatGas when they are motivated to appear on T.V. or send in dire notes via Blackberry to the microphone holders, but we do wish they would do a better job of disclosing their positioning when they do.

Rig Rates Have Risen – To a Low Level

While the idea that the rig rate is climbing may sound imminently bearish, the price of NatGas is relatively low already, so it might help to consider the recent increase in drilling in some kind of context. Luckily, the EIA just happens to provide us a graph showing the U.S. drilling activity specifically for NatGas in the lower 48 states. Presto:



While we have to admit that the rig rate drilling for natural gas has increased for seven consecutive months, when we compare today’s 941 rigs to the previous, say three years of activity, drilling for NatGas is still on the low side. That is likely because we are still digesting all the new shale gas wells brought on line the previous several years.

Rotary rigs reported drilling for natural gas bottomed in June of 2009 at 691. After seven months of increases to 941 rigs now turning, the 2008-2009 historic plunge in NatGas drilling appears to have ended. That’s the last little “hook” on the graph above.

However, one year prior to June of 2009, in June of 2008, there were still 1,510 rigs exploring for natural gas. That shows the power of very high prices. (Ed note: In June of 2008 NatGas had just peaked near a ridiculous $13 per MMBtu, proving the “cure” for high prices is high prices.) In June of 2007 ( a year earlier) there were 1,483 rigs turning and in June of 2006 there were 1,376. We have to look all the way back to June of 2000 (677 rigs with NatGas near $4.50) to find a month with fewer rotary rigs that were looking specifically for natural gas than June of 2009.

Sometimes eyes just glaze over when there are a bunch of figures in a paragraph, so the upshot of that statement just above is that yes, the rig rate is moving higher, but it is still well below where it has been in recent years.

If we compare last week’s Baker Hughes report of 941 rigs to all the months from January of 2009 prior, we have to go back to September of 2003 (6 years) to find a month which shows fewer than 941 rigs looking for the cleanest, most fuel efficient domestic energy source available in North America.

Production Not Keeping Pace?

The natural gas producers have done an admirable job of finding new sources of natural gas and perfecting the technology necessary to produce it. That’s the good news. However, what is lost in the discussion is that these new “tight” shale gas plays are both very expensive to drill and they tend to come in strong, then decline in production rapidly.

We borrowed this graph of first-year decline rates of gas wells in Texas from TheOilDrum.com .



The graph is self-explanatory. In 1971 a new gas well could be expected to drop about 10% in production after the first year. There were no horizontal “tight” gas wells drilled in Texas in 1971. The technology hadn’t been invented yet and really wouldn’t come into wide use until the middle 1990s. As of 2005, the first year decline rate was over 60%, meaning that production from new wells declines very quickly in the first year of production with newer, horizontal “tight formation” gas wells.

Some sources say the year-1 decline rates are approaching 70% today when all shale wells are factored in.

Not all shale wells are the same and production declines vary from field to field, but we think that graph tells a compelling story for the entire shale gas patch. The most obvious point is that it takes more wells and more drilling now to maintain the same level of natural gas production. Perhaps less obvious, but just as important, the effects of high or low prices should show up and be felt a lot faster these days than in decades past. If our unscientific, back-of-envelope analysis is correct, about six times faster. (Y-1 decline of 10% versus 60%+).

When we consider that the depletion rate of new “tight” gas wells is very high in the first 12 months of production, and we add that to the fact that the rig rate bottomed in 2009 at less than half of the 2008 peak, we just might be moving into a period when we are seeing rapidly declining production from existing wells at the same time we have fewer new wells coming on line to replace that production – for a little while – until the price returns to a level which sparks another drilling rush.

Open the Vulture Opportunity window.

Summation

Here’s the quick conclusion of this gaseous trip to “Comparisonville.”

·Natural Gas is cheap any way one wants to look at it.

·Contrary to conventional wisdom and to recent “Big-Gass-Bear” T.V. talking points, there is not really all that much more gas in storage than normal, about 10% more than the 5-year average.

·Drilling for NatGas has picked up, but remains at a relatively low level compared to recent years.

·Much of the new NatGas production is from “tight” shale gas plays, which have very high depletion rates, so it takes more wells to keep the gas flowing.

We could be wrong, but while we could see natural gas futures trading to even lower levels soon, we plan to try to take advantage of any further weakness, as good Vultures sometimes do. We just don’t think NatGas can stay so strongly underpriced in the current environment.

We would normally rather play it through the natural gas heavy royalty trusts, like San Juan Basin Royalty Trust or Permian Basin Royalty Trust, but compared to where they were this time last year price wise, they are definitely not as interesting as then. We’ve already booked our dandy profits on them from last year’s foray into the gas space. Still they both pay handsome monthly distributions, and that’s a lot better than paying margin rates to brokers.

The CME futures are a dangerous and expensive place to try to play it given the still too-wide contangos there, so perhaps it is time to once again consider the NatGas ETNs, such as the IPath Dow Jones-UBS Natural Gas Subindex Total Return ETN (GAZ) or the more popular ETFs, such as United States Natural Gas Fund (UNG). They have recently been trading at much closer to their NAVs as compared to last year at this time when the CFTC was first rattling investor cages in the energy markets and overly wide premiums had developed on them.

The premiums are gone now, and both tend to track short term moves in the daily price of NatGas, but with the wide contangos in futures they will likely continue to see “slippage,” just not as much as last year.

For short periods of time, say a few weeks or months, we can see taking a shot at a natural gas “imbalance conversion” with an ETN or an ETF and maybe both in the very near future. Not without well-placed trading stops, as always, and not without a well-defined entry/exit strategy going forward.

Lest we forget to mention it, we will remind ourselves and everyone reading that just because something is “cheap” that doesn’t necessarily mean it’s a “buy.” Imbalances tend to get strangely and wildly a kilter before they come crashing back to reality in this biz, so easy does it. By looking at a range of comparisons and the historical averages we can reduce some of the guesswork; maybe even gain enough confidence to trade it, but no one can see the future and all we ever have is probabilities to work with.

Full disclosure, we added a first tranche of both GAZ and UNG this past week. We did so thinking we just might be a little early in the game this time, willing to add once, but only once at lower prices for an entry average play, but we’ll see. We may add more in the very near future, if the “Big-Gass-Bears” get really, really frisky on the T.V. in April.

It has been our experience that they tend to show up aggressively just before the market puts in one of its signature high percentage reversals. And of course we Vultures just love those too.

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