What will it take for Natural Gas prices to fire up?

Natural Gas prices have been wiping the floor lately by hitting one new low after another. As such, the impact on natural gas weighted companies, especially the junior producers, has been devastating in terms of share price abuse. For instance, how do the investors that participated in Delphi Energy’s equity offering at $2.75 a share feel after losing almost 40% on their investment since June of 2010? This is but one example amongst many.

Why is this happening?

The answer is simple, there is too much supply. Horizontal drilling technology and improved completion techniques have opened up huge reserves across the shale basins of the United States. Shale is rock formed from very fine grained to clay-like sediments that have been compressed over time trapping organic material. The same heat and pressure that turned the mud into shale also ‘cooked’ the organic material, creating natural gas. Shale gas could supply 100 years of consumption at current rates!

Alleviating the pain

The following 3 variables will be impacting natural gas prices for 2011:

Winter 2010-2011: AccuWeather.com Chief Long-Range Meteorologist Joe Bastardi is predicting that the worst of winter’s cold and snow will be from the Pacific Northwest into the northern Plains and western Great Lakes. Bastardi also predicts late November and December could get winter off to a fast start in the East, with a major thaw coming for much of the country in January.

The main player governing the forecast for this winter is the phenomenon called La Nina, when sea surface temperatures across the equatorial central and eastern Pacific are below normal. La Nina winters are typically synonymous with harsh conditions across the northern tier of the United States and drier-than-normal conditions throughout the southern tier.

While weather predictions are a dime a dozen there is another report inline with the same forecast. What should be noted here is that a colder than usual winter would definitely help natural gas prices as it would increase the weekly draw for heating purposes.
Gas Producers Exhibiting Discipline: Drill happy producers have to get their act together or they will simply be ruining prices for an extended period of time. Here I will quote from a Credit Suisse report released on October 21^st.

Further evidence of producer capital discipline has emerged in a low price and high service cost environment. ECA yesterday noted that it would resist high completion costs by slowing activity and shifting to custom fit-for-purpose completion equipment in the Haynesville. ECA also said that it plans to allow some acreage to expire in the Haynesville, consistent with other operators such as HK and EOG. It also noted the potential for shut-ins. OXY also announced on its call earlier this week that it plans to cutback drilling in its Mid-Continent region and maintain just a two rig Rockies program due to low gas prices. This follows other producers such as GMXR, SD and DVN reducing dry gas drilling activity due to weak economics.

Here’s an interesting bit from EnCana’s Q3 release:

“North America’s ongoing oversupply of natural gas production has driven prices for the near term to levels that we believe are unsustainably low. As such, we are slowing the near-term growth rate of our resource plays.”

According to a report last Friday by oil services firm Baker Hughes in Houston the total natural gas rig count fell 26 rigs or 3% from the recent peak of 992 rigs. A continued reduction in drilling would see dry gas production begin to show some declines during 2011.

Increased use by the Industrial and Power sectors: A stronger economic recovery would certainly help natural gas prices as the industrial base of the US used 34% in 2009. On the same note, an increased use of natural gas for power generation by adding new plants or converting existing ones from coal will also make a difference. Why would natural gas be preferred over coal? Simply because it is the least pollutant per BTU produced and with plenty of cheap accessible supplies.

While both variables seem to be a sure bet for the future, 2 Problems are worth mentioning:

1.             The US economic recovery is going nowhere fast. Unemployment is stuck at 10% which means a full recovery will be long in the making.

2.             Converting existing plants or building new ones for power generations takes time. Getting through the regulatory paperwork probably takes longer than building the plant.

Final thoughts

The good news is: There is hope for a natural gas price recovery in the future.

The bad news is: No one knows when the turnaround will decisively start with NG since all the measures discussed above take time.

Now that the forward curve for natural gas prices have collapsed, the majors can no longer hedge at higher prices 2 years out. The only cure left for low prices are lower prices since it will devastate a company’s cash flow and force it to focus its capital on liquid targets such as oil or LNG which are traded as an international commodity.

It’s funny how I mention cash flow devastation when I am exposed to natural gas through some of my stocks and as such currently going through significant paper losses. Unless you’re a happy long term investor for buying natural gas stocks at a discount, winter is around the corner and while one should not put all of his hopes on winter, it can potentially sustain NG prices long enough for anyone who wishes to exit his stocks at a minimal loss or a small profit!