The Natural Gas Opportunity

“Profit Confidential” Column, by Michael Lombardi, CFP, MBA, with help from Anthony Jasansky, P. Eng.

The reduced demand of a contracting North American economy, mild weather, and rising U.S. production from unconventional sources took a heavy toll on the natural gas market between July 2008 and October 2009. Even following the 100%-plus rebound of the last three months, natural gas remains deeply undervalued on the basis of cost per unit of energy provided by natural gas versus light crude.

More recently, large weekly storage drawdowns, caused by the unusually deep cold spell and some shutdowns of marginal wells, helped natural gas prices to rally from the late September 2009 low of $2.41. In the short term the weather forecast will continue to add to the volatility in natural gas prices. However, the $4.30-$5.10 range is likely to provide good technical support.

As for the intermediate and long term outlook, the Energy Information Administration (EIA) data show that the gap between total U.S. production and consumption of natural gas has narrowed over the last two years. Rising production from new unconventional reserves, rather than declining total consumption, has been the reason for the declines in imported volume of natural gas.

The trend in consumption by the four largest groups of natural gas users shows that, while the industrial demand continues its steady long-term decline, the consumption by electrical utilities has been increasing. Demand from the other two large users, residential and commercial customers, has been flat, fluctuating with weather changes.

The decline in natural gas prices has been accompanied by a comparably large decline in the number of rotary rigs in operation. The number of rigs in operation has bottomed out at about the same low levels last seen back in 2001/2002, when natural gas briefly dipped below $2.00. The latest cyclical downswing in demand for rigs is likely to be translated into a cyclical downswing in the number of new producing wells coming online in the coming months.

In summary, our guess is that a rebound in natural gas prices will resume, with the potential of reaching the $6.50-$7.00 range during this winter. While most of the natural gas stocks are currently short-term overbought, any correction in the price of natural gas should be viewed as an opportunity.

Michael’s Personal Notes (with help today from Robert Appel):

For the last four or five market sessions, Internet chat boards have been buzzing about an interview done last week on CNBC by host Rick Santelli. In this interview, there was speculation that the U.S. is actively looking to change the shape of its 401K and IRA mechanisms to “empower” average Americans into buying their own sovereign short-term debt. One thing we know for sure is that, whereas CNBC usually posts all these interviews on its web site right afterwards, this one is missing.

What is the angle? The prevalent thinking by some is that this is a “first step” by Washington to test the waters and see if a mechanism can be derived to get “the guy in the street” to buy short-term U.S. debt at interest rates that are low since the usual buyers (overseas buyers, countries, sovereign funds) have, for the last few months, been taking less and less of this stuff, as they are seemingly waiting for higher rates.

OK, let’s take a step back:

The U.S. has been unwilling to raise rates in an environment of low employment, because to do so could cause us to instantly revisit the 2008 debacle, and then some. Specifically, high rates would move the U.S. economy from recession to depression; would increase unemployment; would destroy the bond market; and would remove 50% of the value of the stock market in a matter of months, the argument goes.

More importantly (and this may sound cynical) sharply higher interest rates could open the door to civil unrest in a way that America has not seen for at least a half-century. Moreover, given the fragile economic conditions in most major cities and states, it could trigger an event to which only a federal response by the Armed Forces could be adequate.

Traditional buyers of U.S. short-term debt have basically been buying less and less, at a time when the U.S. is printing money so fast that it is making more and more debt. Even the most jaded analysts now concede that, for the last several months the Federal Reserve has been “buying” or otherwise absorbing a significant amount of U.S.-issued Treasuries (bonds).

The year 2010, it seems, is where the rubber hits the road. In 2010, the “deal” that the U.S. cut with its pals in 2009 to keep rates low expires, and already other countries are raising rates. So, bottom line, the U.S. could be getting desperate for the buyer for the debt it so desperately needs to issue to finance its ongoing obligations.

The recent currency devaluation in Venezuela has only added fuel to the fire.

Mysterious selling forces in this same period are hitting oil, gold and commodities hard, but they stubbornly refuse to go to the canvas and “take a dive.” Odd.

Just when you think you’ve seen everything, the U.S., in what some would say is a desperate move, could be coming up with a plan to “steer” its own citizens into their own debt. I guess, when all else fails, why not sell your junk to your own people and let the public be damned once again.

Where the Market Stands:

The Dow Jones Industrial Average starts this week up 1.75% so far for 2009. Gold’s doing better than the stock market, with bullion up 3.5% so far for the year.

Reports from big companies have been quite positive this earnings season. Investors are starting to hear and feel the positive news coming out from the earnings reports, and this will add to more money returning to the stock market.

Let’s not kid ourselves. There is still plenty of negativity out there about the economy and stock market. The job of the bear market is to take that negativity away and bring investors back into stocks. That is exactly what the bear is working on right now.

What He Said:

“What group of stocks are next to fall in light of the softening U.S. housing market? The stocks of companies that sell retail products to the American consumer, I believe, are next on the hit list. Many retail stocks are already reporting soft sales. In my opinion, they haven’t seen anything yet in respect to weaker sales.” Michael Lombardi, PROFIT CONFIDENTIAL, August 30, 2006. According to the Dow Jones Retail Index, retail stocks fell 42% from the fall of 2006 through March 2009.