Tuesday, January 31, 2012

natural gas in the U.S.

After last Saturday's post on earnings (which was admittedly uninspired) I've been thinking a lot about the overall business outlook with an eye cast towards the U.S. market today. The seasonal nature of the natural gas business in the U.S. is not something most people ever need to know about. For most people, their relationship with gas is that when they turn on their stove or fireplace or flame thrower, it has a supply of gas and they pay for that gas each month. Or perhaps they have a large propane tank and they pay whenever they have the tank refilled. Either way, it's much like other utilities such as electricity and water. You use it, you pay for it, and you don't give much thought to where it comes from. The answer is that it comes from the ground and then, after traveling through a series of tubes that are surprisingly similar to the internet's tubes, it ends up in your house or CNG vehicle or super-villain lair. OK, part of that answer was not strictly accurate. Nor does this address how or why the natural gas business is seasonal.

The answer is in this chart from the U.S. Energy Information Administration. That is a chart of underground natural gas storage in the U.S. During the year, gas production is roughly constant which you can see if you head here and scroll down until you find the Daily Suppy/Demand Graph [sic] with a typo reminiscent of some of my best work. The total supply is roughly flat all year round, but consumption varies widely going through a cycle each year of being low in the summer to high in the winter. To accommodate this elasticity in demand, a good portion of gas produced in the summer is stored underground until it is needed in the winter. This cycle happens every year and gives the underlying industry much of its seasonality.

Each year, the industry watches quite attentively throughout the winter to see what is happening with storage. This year, if you revisit the first chart you will see that current storage is at a very high level for this time of year. While that chart only shows ranged bands for the last five years, storage levels are indeed at record highs and are actually about 20% over last year's levels. This has been brought on by a combination of a very mild winter in much of the country and improved production techniques that have allowed for the faster production of large quantities of gas. Tomorrow (relative to the day this is being posted) is when the previous week's figures will be released and you can see if there's been any closure of that gap now that at least some of the country is starting to experience a proper winter.

The high storage levels have understandably led to weak spot market prices. This is not to say that you as an individual are paying less for gas since you are probably tied to some contract. In fact, from this chart here you will see that residential customers pay more than consumer users who in turn pay more than industrial users and power plants. It's not that you're getting screwed (sort of), but you probably don't have the resources nor consumption levels to make negotiating a better individual price worthwhile. Anyway, the spot prices are down as seen on the second graph down under Spot Prices Graph. In fact, from their peak in mid-2008, spot prices are down to less than a quarter of peak levels.

These weak prices are of course cause for much consternation amongst natural gas drillers and producers. No one really wants to be producing more and being paid less. Some drillers, including heavyweight Chesapeake have signaled that they will shut-in some production and reduce drilling in an attempt to remedy the situation. Whether such moves will achieve their goals are not clear, but they have a very limited number of levers at their disposal to pull (and I cannot help but think that only the Fed with their prime interest rate lever is more limited). This announcement was made two weeks ago, coincidentally on the same day that Halliburton reported relatively strong earnings. Unfortunately for HAL, their own good news was washed over by the concerns surrounding Chesapeake's announcement and HAL's stock price tumbled that day. I'd pretend to be sympathetic, but this is the internet where you're pretty much obligated to be an anonymous jerk. In reality, it will be interesting to see how many other major drillers follow CHK's lead and also curtail U.S. drilling in 2012. That will trickle down to the service companies in a rather significant way and with Halliburton's relatively large exposure to the North American market, this is why they took such a large hit over this news.

What does all this mean for natural gas prices in the future? If there is an attempt to prop up prices through reduced production, how effective will it be and can you do something about it? The short answer is that no one is sure and you as an individual hold little away over market forces. Unless you're super fabulously wealthy. Are you super fabulously wealthy? If you are, I have this Nigerian prince friend who wants to go in for half of a business venture but due to some legal issues you'll have to put up your half of the money first. If you're not super fabulously wealthy and are looking for a somewhat legitimate investment, you could buy into the United States Natural Gas Fund (UNG) which is an ETF that seeks to mirror the spot price of natural gas in the U.S. In a sense, if you look at the five-year chart it's incredibly cheap. You will see a similar trend with another similar ETF called GAZ and that five-year chart which shows a peak in mid-2008 and a brutal slide down since then. The problem with both those funds extends beyond the weakness in natural gas pricing. With the way they try to mirror natural gas prices through the purchase of options contracts, the up- and down-sides are magnified. Additionally, there was a period of time for UNG where it had become such a large fund, that it's purchasing habits of options contracts was starting to have unintended influence on the options market. Personally, and I am not an actual investment adviser*, prices seem close to the bottom, but I'm not sure they will meaningfully rebound for some time. Even with curtailed domestic production, LNG imports are waiting in the wings making supply readily available. I guess what I'm trying to say is that you should buy gold. Lots and lots of gold because it never goes down in value**.

* In addition to not being an investment adviser, I am also not technically a doctor despite my nickname. Nor can I represent you in a court of law. Well, unless you're me since I can represent myself, which in that case would be you, but the odds that you are me and only just now realizing this are staggeringly low.

** Except for 1980 to 2001, so perhaps you'd be interested in some Dutch tulips instead.

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