Nat-Gas Backdrop
As global demand for energy generally and natural gas specifically continues to increase, I am becoming more and more convinced that we’re headed for structurally higher natural gas prices. By structurally, I mean to say that natty below $3 at the Henry Hub could be a relic of the past.
The financialization of oil & gas production and fracking over the last decade led to artificially low natural gas prices.
The gas production boom from Appalachian fracking, followed by the glut of associated gas from Permian crude oil production is not easily duplicated. Meanwhile the US, and increasingly the rest of the world via LNG, have become reliant on those artificially low prices.
Natural gas inventories worldwide are at extremely low levels and winter is just two months away. If they are not filled to normal levels this shoulder season and we have a bad winter, we could see catastrophically high natural gas prices. By catastrophic I’m thinking of a scenario along the lines of the Texas Freeze, but on a much larger scale. We could be in a full blown energy crisis in as little as four months from now. This is what natty futures are beginning to price-in, see below:
In terms of dry gas production, high prices cure high prices, at least typically. This time is structurally different because you have a situation where all of the premium acreage has been drilled, and all of the vast sums of easy money have been spent across the Marcellus and Utica Basins of Appalachia. What producers are left with are steep production decline curves and huge CAPEX requirements in order to even attempt to hold future production steady on mostly second tier acreage.
Associated gas from crude oil production could help alleviate the situation. High oil prices could spur another round of production CAPEX and a Permian-like production boom could ensue. However, OPEC+ has their expert hands on the tiller of global oil production, adjusting prices so they stay high, but not too high else US fracking could ruin the party.
We’re therefore in a sweet spot of inelastic demand.
In economics, inelastic demand occurs when the demand for a product doesn't change as much as the price.
Coal Implications
Natural gas demand is sticky. It’s not easy to shift back to coal. They’re not building more coal fired power plants in the US. The coal generation fleet that remains has excess utilization capacity however, so the share of coal burn can increase but only marginally.
There’s whispers of $14/ton PRB coal in the coal rags and on Twitter this morning. We haven’t seen $14 PRB since 2014! These prices are rallying because utilities are having to compete with the export market for every ton of coal. Utility coal stockpiles are being drawn down in China, India, and the US. Meanwhile, thermal coal supply remains extremely constrained.
How to Invest
Coal equities offer an intriguing amount of leverage to higher natural gas prices, especially since companies like Peabody (BTU) were almost in bankruptcy only 10 months ago. The problem is we have to wait for investors to see the flow through of higher prices and higher volumes somewhat before the fundamental reality gets priced into the share prices. Of course there’s share appreciation as early investors with an edge get in early, like those of you who subscribe to this newsletter for example, but the big institutional capital flows doesn’t really have an edge, and they’ll probably arrive late with their wait and see approach.
Therefore, it may be easier to simply trade the catalyst itself and not a derivative thereof. If we’re banking on catastrophically higher natural gas prices, then we should simply trade natural gas itself! Without getting into futures products, which is beyond the scope of this article (but I may dabble with for premium subscribers), there’s a few ETF’s which may suit your needs:
UNG: The United States Natural Gas Fund
This ETF benchmarks Henry Hub “near month” contracts within two weeks of expiration. So there’s a roll liability and some expenses, but it’s an easy way to make short term trades that track HH.
The options for this ETF are extremely liquid.
UNL: The United State 12 Month Natural Gas Fund
This ETF also benchmarks HH, but has exposure to the full 12 month futures strip. Meaning, it holds the near month and all of the following 12 month contracts, equally weighted. This ETF therefore doesn’t move as as much volatility as UNG, but does give you exposure to the 12 month forward curve. Therefore, if you think natural gas prices are structurally too low and you expect the entire curve to shift upwards, then UNL could give you buy and hold-type performance returns. This is different than UNG, which I view strictly as a trading vehicle only.
Natural Gas Producers.
Obviously, there’s a long list of natural gas production companies that could be an interesting bet on structurally higher gas prices. I’m not an expert on any of them in particular but if you want exposure to near term prices be careful not to buy one that has hedged a significant amount of their near term production.
Summary
Commodity price risk remains to the upside. Things could get very weird this winter.
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