Natural Gas – How Low Can It Go?

Hi Everyone,

Instead of looking at stocks this time round a bit of change of tack and a look at Natural Gas instead. This is the first time I’ve covered Natural Gas but have found the recent price action very interesting so thought I’d share a few thoughts on it and take a look at whether a rebound is due anytime soon or if the steady 14 month decline it has been in is likely to continue. Compared to it’s big brother Crude Oil, Natural Gas is no where near as popular when it comes to press coverage or trading for that matter. But it is still a vital and very interesting commodity and one which I feel could offer up an interesting trade over the next few weeks.

A Volatile Commodity With Extreme Moves

Let’s start by taking a look at what Natural Gas prices have done over the last few years. Below is a 5 year chart and a quick glance shows us that natural gas prices have certainly moved around over the years. Back in 2005 the price jumped from $6 per 1000 cubic feet to almost $16 in the space of 6 months. It then crashed right back to $6 over the next 6 months. Last year we saw a similar trend with Nat Gas almost doubling between January and July when it rose steadily from $7 to $14 before reversing sharply to end 2008 at around $6 per 1000 cubic feet. And as we have moved through 2009 the downward trend in gas prices has continued accelerating in recent weeks to leave prices hovering around the $2.60 mark at today’s close – that’s a massive 80% fall in the price of natural gas since July 2008 and it’s lowest price in since March 2002!

Over-supply and Huge Inventories Driving Prices Down

So what’s driving this massive fall in prices? Well the main reason is a massive supply glut that has occurred over the last year or so. As the global economic crisis took hold manufacturing has been scaled back significantly resulting in a reduced demand for natural gas from factories across the US and further afield. The interesting thing is that while demand has clearly reduced that has not stopped natural gas producers from pumping out additional supply week after week. All this additional supply goes into storage and there is now almost 3.3 trillion cubic feet of natural gas in storage in the US. The big issue now is where to store additional gas over the coming months if supply continues to outpace demand as it is thought that peak capacity in the US for storing natural gas is 3.9 trillion cubic feet. The price of storage is going up and building additional storage space is not cheap.

Current Disconnect Between Oil and Gas Prices Is Unusal

So there’s no doubt the current low gas prices make sense, if all that supply exists and is growing by the week and no significant pick-up in demand on the other side then yes, of course prices will fall. But what I find a bit unusal is while Nat Gas prices have been falling through the floor since the start of the year Oil prices have nearly doubled from $40 a barrel in January to about $75 as recently as 2 weeks ago. Obviously OPEC are doing a better job at controlling supply (and prices) than the nat gas producers in the US! This divergence in oil and gas prices is quite rare however, normally the two are closely correlated, with high gas prices usually occuring inline with high oil prices and vice versa. Historically oil prices have traded at 6 to 12 times natural gas prices. At today’s prices oil is trading at a ratio of over 25 times the price of natural gas – further highlighting the extraordinay divergence that has occurred this year.

Calling the Bottom

So where to next for Natural Gas prices? Well personally I think they can’t continue to go down forever, but as always, markets can often move further then any of expect in a given direction, and as highlighted at the start of the post nat gas is certainly no stranger to extreme price movements. The other thing with natural gas is that well at least we know where the bottom is…and having fallen from close to $14 per 1000 cubic feet last year to just above $2.40 last Thursday, well the absolute bottom isn’t too far off now…and I can’t see suppliers giving gas away for free anytime soon! I’ve repeated on many occasions the importance of not trying to call the bottom on a market and natural gas is no different. While I do think it’s severly oversold at this stage and due a rebound the recent break of support at $3.20 (see chart below) has seen a significant sell-off as one might expect when a strong support level is broken. Since if broke this support the week before last natural gas has gone on to fall almost 25% and whose to say it won’t fall another 25% or more before recovering.

Factors Which Could Lead To A Price Rebound

So what are the factors the could signal a recover in natural gas prices? Well we have already spoken about the massive divergence in natural gas prices when compared with oil. I think sooner or later this price divergence will have to close, either by natural gas prices rising, oil prices falling or a combination of the two.
A second factor is that we are coming into the winter season in the US and homes across the country are going to start eating into those natural gas supplies discussed above. A severe winter or a milder one will have a massive bearing on how the demand for natural gas pans out. For example over 70% of homes in the mid-west United States using natural gas for their home heading.

A third factor would be if the continuous supply were to get hit. So far hurricane season in the US has being almost non-existent with no major storms hitting the gulf coast so far. Hurricane season runs until the end of November, should any major storm threats arise over the coming months which lead to the suspension of drilling expect to see the price of natural gas to move up.

Finally and probably most important is the global economic recovery. If things continue to improve and the US does come out of recession in the coming quarters, as growth returns to the world’s largest econmy then with it will the demand for natural gas.