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Natural Gas: The Forgotten Commodity, But Not By Exxon Mobil

The commentary below is for the benefit of our readers from opinion makers and writers not associated with Euro Pacific. We do not guarantee the accuracy and completeness of third-party authored content. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific, or its CEO, Peter Schiff.
Dian L. Chu
December 15, 2009

Exxon Mobil (XOM) announced this morning that it will buy XTO Energy (XTO) in an all-stock deal worth $31 billion as the oil giant moved aggressively towards the abundant unconventional natural gas source at home.

This deal shows the priority that major producers are giving to natural gas as a fuel source, and could signal a new rush to own natural gas assets by other majors.

The collapse of the global economy and unfolding credit crunch has conspired to send natural gas on its fastest decline this year hitting $2.41/MMBtu on Sept. 4, the lowest level since late 2001. Throughout much of this year, natural gas has become an almost forgotten commodity with poor market fundamentals keeping a lid on the price.

Over the past three months; however, natural gas has fared considerably better finishing last Friday at $5.278/mmbtu, near 11-month high on news of the first inventory draw in nine months benefiting from frigid temperatures throughout the country. (Fig. 1)

Gas traders were taking advantage of last Thursday's 8% run-up spurred by a surprisingly large drawdown of 64 bcf of U.S. gas inventories to sell contracts at relatively high prices.

Natural gas futures have gained about 9% this month, albeit still down 6% this year. While the price spike shed a ray of light on to the shale-shocked fuel, analysts are divided whether the price rise would provide long-term warmth.

Some analysts expect prices bottoming out as the winter wears on, and production cuts roll in; whereas others see a definitive bearish outlook citing the still high inventory and new global LNG capacity. However, weather is weighing prominently at both camps.

Here are some of the facts from the U.S. Energy Information Administration (EIA) and Baker Hughes Inc. (BHI) regarding the natural gas market:

  • Lower Withdrawal - According to the U.S. EIA, despite exceeding market expectations, the net withdrawals were less than the 5-year average withdrawal of 90 Bcf as well as below the withdrawal of 66 Bcf for the same period last year.
  • Inventory Still High - Even with the larger-than-expected pull from storage, gas supplies remain ample. Total gas in storage as of Dec. 4 was still about 16% above the five-year average and 14% above last year's level.
  • Small Production Decrease - The latest report from the EIA shows a sequential 2% drop in natural gas production in the lower 48 states. (Fig. 2) The EIA attributed this to "natural gas plant maintenance, repairs and shut-ins due to low gas prices". A pipeline interruption during the month was one of the factors that lowered the production.
  • Shale’s Up – The current Baker Hughes natural gas rig count of 757, though 45% lower year-over-year, is at its highest since April 2009. The increase in the horizontal drilling activity suggests that shale/unconventional is a clear industry focus. (Fig. 3) Barnett, Fayetteville, Haynesville, and Marcellus are some of the popular shale plays where production is robust and economics are modestly better.
  • Coal-to-Gas Switch Increased - Price competition between coal and natural gas is intense, and the collapse in Henry Hub price has been reflected in fuel selection. Based on the EIA latest data, consumption of coal for power generation in August 2009 was down by 9.1% year-over-year, while consumption of natural gas increased by 9.9%.
  • LNG Wild Card - So far in 2009, lower prices in other main liquefied natural gas (LNG) markets coupled with abundant gas storage infrastructure has pulled LNG cargos to U.S. shores. Through the end of September LNG imports are up 38% year-over-year. Fortunately, the LNG influx coincided with a drop in imports from Canada, or the current domestic storage level would have been a lot higher.

Fundamental Outlook

The continuing influx of LNG demonstrates that massive storage capacity and a liquid market will continue to make the U.S. the market of last resort for LNG, even during periods of low prices. With new liquefaction capacity coming onstream (Fig. 4), the level of U.S. imports will be contingent upon the arbitrage in the global LNG markets.

Nevertheless, the current consensus seems to be that the “dark stormy night of natural gas” has come to pass. Though the fuel might not get much help from the supply side, the demand side of the equation certainly looks a lot brighter than 6 months ago.

A weak dollar and a recovering U.S. economy should boost demand from the industrial sector. The continued growth of wind and solar energy capacity would require more backup supplies, and natural gas is by far the most reliable. The government’s green initiative is also positive for the natural gas as it is a cleaner fuel option.

A colder winter forecast, a recovering U.S. economy and the alternative energy push all are favorable signs that some of the excess inventory could get burned off thus igniting the depressed natural gas market. On that note, natural gas should be able to at least maintain the current $5 levels with some potential upside to the $6 - $8 range next year, depending on the pace of our economic recovery and, of course, weather condition.

Technical Momentum

A record 408,214 natural gas futures contracts traded last Thursday on the CME Group Inc.’s Globex electronic system and on the floor of the NYMEX, according to data compiled by Bloomberg.

Other technical indications are also bullish. For example, the fast average is above the slow average and price is above the moving average. So, there could be some more technical upward momentum during this winter season.

More Industry M&As?

The Exxon-XTO deal could prompt further consolidations as Exxon Mobil is generally regarded as the industry leader and trend setter. Most oil majors like Royal Dutch Shell PLC (RDS), BP BLC (BP) or Chevron Corp (CVX) typical do not possess as much the technological expertise in unconventional gas as the pure E&Ps, and would most likely look to acquire the independents under the current more favorable valuation base.

Natural gas weighted E&P companies such as Devon Energy (DVN), Chesapeake Energy (CHK) and EOG Resources (EOG) could be potential targets.

Close to the Bottom & Non-Dollar Reactive

Although natural gas has underperformed almost everything else in the market this year, it is probably the only asset class where investors may still get in close to the bottom in light of the market run-up this year.

Last week also marked the first time since October that oil fell below $70/b, partly reacting to the dollar strength, while natural gas moved in the opposite direction. This illustrates one unique characteristic of natural gas - it does not react to the movement in dollar like other commodities, such as crude oil or gold, do.

Rational Allocation

With dollar seemingly staging a comeback from an oversold situation, and the general expectation of higher interest rate next year, allocating a portion of portfolio in investment vehicles related to natural gas producers and/or land drillers could prove to be a logical and prudent move.

While futures-based commodity ETFs such as United States Natural Gas Fund (UNG) may look like an obvious option, I will reiterate caution against this type of investment due to volatility, transparency, among a number of other concerns.

Dian L. Chu, M.B.A., C.P.M. and Chartered Economist, is a market analyst and financial writer regularly contributing to Seeking Alpha, Zero Hedge, and other major investment websites. Ms. Chu has been syndicated to Reuters, USA Today, NPR, and BusinessWeek. She blogs at Economic Forecasts & Opinions.