Young and Invested

Why Natural Gas?

The NYMEX Natural Gas Futures (Front Month) hit 10 year lows of around $2.50 a few weeks ago and have since sky-rocketed to around $4.80 at the close of Oct 9, 09. In the process, it has very powerfully broken the downtrend that it was in for the past year. This could well be the best opportunity to get exposure to natural gas, here’s why:

1. The period of seasonally high demand for natural gas is nearly upon us. With forecasts of a harsh winter in North America, the additional heating usage will provide the necessary demand that has been missing for the past quarters. The market perception is that the inventory overhang is too large for a demand increase to cause a recovery in prices. I continue to believe that the market is over-reacting to the supply glut – producers have already been cutting production for months as the National Energy Board has said drilling in Canada and the US has already slowed to half the level of previous years. July 09 data shows the number of operating drills in the US is down 55% (or down by 851 rigs) year-on-year.
2. The economic recovery itself will increase demand for natural gas from the big industrials such as Dow Chemicals. Steel producers will also contribute to demand as their markets recover. Both industrial production and manufacturing numbers have been positive in the last few months. The recovery and the weather will help reduce the large inventories of natural gas in storage.
3. The US government is continuing to push on clean energy initiatives that will reduce greenhouse gas emissions. One example is the DOE Clean Cities Program through which $300 million has been earmarked for the advancement of alternative vehicles on the road and a significant number of these projects involve natural gas. Clean energy acts around the world focus on reducing coal-produced energy in power plants and at the moment, natural gas is the next best alternative. Wind and solar energy are still too expensive in terms of $/kWh to match the power needs. In 2008, 21.3% of US energy production came from natural gas while all other renewable energy sources made up 9.8% of production. It’s important to point out though that the power hungry economies of India and China have little impact on natural gas prices in North America, because natural gas, unlike oil, cannot be transported across oceans easily (except LNG), resulting in markets which are very geographically separated. LNG is not an important enough factor yet – LNG requires major investment in ports to provide access to LNG tankers and in liquefaction and gasification plants on both ends of the transport route. As of Dec 08, there were only 8 LNG terminals in the US.

The wild card may be shale gas and new drilling technologies that have lead to soaring on-shore production. It is hard to predict how much of an effect this new production will have on supplies and whether it will be enough to offset curtailment in production elsewhere.

As I see it, there may be some limited downside to natural gas prices at this point, but there is quite a huge upside potential. NG futures seem to be pricing this already in as the Feb 2010 futures are trading at a 28% premium to the Nov 2010 futures.  Aside from the decision to go long, an equally important decision is to figure out where to invest along the natural gas value chain which is very long and has many participants. I will write about the possible strategies of getting exposure to natural gas in Part II of this post.

Disclosure: Long GAS.TO

Image credit: Nandu Chitnis under a Creative Commons license

Last 3 posts by Shishir Nigam

• When Correlations Collide - March 7th, 2010
• Is the United States an “Emerging Market”? - February 28th, 2010
• It’s Time To Accept The C$ At Parity - February 21st, 2010