Friday Natural Gas Report: It was the Best of Times, It was the Worst of Times

Conflicting viewpoints on the prospects of the commodity abound in the natural gas sector. Positive data from a meteorological and drilling standpoint contrasts with a very bearish supply report.

The Good:

1. The number of exploratory rigs drilling for natural gas increased by four rigs this week, to 681. This marks the third consecutive increase, an event that has not occurred since June of 2008. This data is shown in Figure 1 below.

Figure 1: Latest natural gas rig counts

On the one hand, a low natural gas count is favorable as it will eventually bring supplies back down. Since last summer when the rig count peaked at 1606, the count has plummeted 57% to a level that has analysts predicting US production to fall as much as 15% by late next year. However, the recent increases in rig counts show that producing companies are regaining confidence in their commodity. With prices under $4/MMBTU, many drilling companies are operating at loss. Thus, the drilling of new wells shows confidence for the relatively longer-term bullishness of natural gas. Historically, a bottoming in the rig count has corresponded with a bottoming in the commodity.

2. The spread between the front month contract (Sept ’09) and the next month (Oct ’09) is 27 cents, or nearly 10%. This is a strong contango, a situation that arises when the near month contracts are cheaper than the later contracts. Figure 2 below shows that this contango extends into the winter.

Figure 3: 12-month spread in NG futures contracts

The extreme spread in this months contract and the next leads me to believe that this contango has to collapse, and soon, either up or down. Producers either continue to produce to take advantage of the spread, which drives the long-term contracts down, or they cut production leading to a bounce in the near-term contracts.

3. Temperatures will rise considerably across a large portion of the country beginning this weekend. The east coast and midwest will likely experience the hottest weather of the summer over the next week. All of the east coast cities will break into the 90s by Sunday, with Washington DC approaching 100. This is bullish from a cooling demand perspective. I will have more a more detailed discussion in my Sunday post.

4. Stocks in the Oil and Gas sector have been very strong performers over the past two weeks (despite weakness in the underlying NG) with many leading names seeing considerable accumulation. While this may be just a byproduct of the broad market rally, it is also possible that speculators like the long-term prospects of the industry and are jumping on cheap names in anticipation of a later rally by the commodity itself.

The Bad

The EIA reported Thursday that natural gas inventories increased by 66 BCF to 3089 BCF for the week ending 7/31/09. This data is shown below in Table 1.

Table 1: EIA storage report data

	Stocks in Billion Cubic Feet (BCF)
	7/24/09	7/31/09	Change
East	1523	1579	+56
West	441	442	+1
Producing	1059	1068	+9
United States	2023	2089	+66

.

The +66 BCF injection is substantially above the +42 BCF average for this time of year and greater than the +56 BCF injection from this time last year. The 3089 BCF in storage is also the highest value in either July or August since records began in 1976. On this pace, we should eclipse the 3565 BCF record set in 2007 by at least 300 BCF.

Worse still, this injection was substantially higher than predicted by analysts. Projections ranged from +50 BCF to about +58 BCF. My temperature-based model projected an increase of +57 BCF. Temperatures were the warmest they had been all summer last week . The fact that the actual injection so greatly exceeded these values indicates that either demand in a different sector has fallen or production has been ramped up.

Right now, it is in the best interests of producers to drill and store gas, due to the strong contango already mentioned. However, over the next month as storage reaches and exceeds record levels, I expect to hear many reports of companies cutting production. Chevron recently announced that by the end of 2009 it will not have a single land-based well active while Chesapeake too announced it will imminently cut production further.

Trading

While warming temperatures may help the short-term storage and the rising rig counts suggest a possible bottom by those in the industry, the high levels of storage do not suggest that gas has the fundamentals to rally. I will continue to hold my UNG position. I also have a large position in CHK from 22.90. While overextended, CHK has broken out of its nearly 8-month trading range.

In this market, I feel that playing the companies is advantageous to playing the commodity. Stocks in the Oil and Gas sector have outperformed both the market and the underlying commodity (NG) over the past two weeks and I feel in the short-term that the risk-reward is better here. I bought some Sandridge Energy (SD) this morning at $10.20, recommended by Cajun. I also like Linn Energy (LINN) here as well, but do not yet have a position. Until I see some tropical activity or get a better idea of this year’s max storage, I will neither add to nor sell my UNG position.

The Tropical Atlantic is quiet right now. Some of the computer models develop a wave between Africa and the lesser Antilles late this weekend. In the Central Pacific, Hurricane Felicia is beginning to weaken as it encounters cooler waters and more hostile upper level winds. As I discussed in my post Wednesday, it poses a rain threat to Hawaii, passing through the islands as a weak tropical depression or remnant low on Monday.

Note: Major Karma Points to the first person to correctly identify the hurricane shown at the top.  This is going to be a common theme of posts for the foreseeable future. A small hurricane warning flag will be awarded to the individual with the most points at the conclusion of the hurricane season, provided that they have at least 12.

Note 2: Today’s storm needs both a name and a year. It is trickier than the others, but the answer is given in the title of the post… Sometimes I like to amuse myself.

1. Wabisabi-8

2. DPeezy-6

3. TraderCaddy-4

4. Yogi and Boo Boo-2

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