The natural gas market cooled down in the past several weeks after the price of the Henry Hub reached its highest level earlier this year. Looking forward, will the price of natural gas keep falling? Also, how the recent developments in the natural gas market may affect the performance of leading natural gas producers such as Chesapeake Energy (NYSE: CHK)?
Natural gas market is cooling down
The colder than normal winter has pushed up the price of natural gas to record levels in some parts of the U.S such as New England. The price of natural gas rallied mostly due to the high demand for heating purposes in the residential and commercial sectors. The elevated demand for natural gas has also reflected in high extraction rate from storage.
The table below presents the change in natural gas total storage and price between November and March of the past several years.
Source of Data: Energy Information Administration
As you can see, the storage depilation rate of this winter was the highest in the past several years. This could partly explain the dramatic decline in the price of natural gas by more than 75%. The current price of the Henry Hub is still high for the season and is well above its level from last year. Nonetheless, the staggering rise in the price of natural gas is likely to change direction in the coming weeks. Let’s see why.
The currently high price of natural gas is likely to steer utility companies away from natural gas and towards coal. The Energy Information Administration expects the demand for natural gas to inch down by 0.1 Bcf per day to an of average 71.3 Bcf per day in 2014. The decline in consumption is mostly in the power sector. Furthermore, on an annual scale natural gas producers aren’t likely to benefit from the over-heated natural gas market during the 2013/2014 winter. Thus, as the power sector continues to cut down on its natural gas consumption and as the winter winds down, the price of natural gas is likely to follow and drop precipitately.
Over the first quarter, however, the tighter natural gas market is likely to improve Chesapeake Energy’s profit margin and revenue. In 2013, the company’s natural gas revenue accounted for roughly a third of its production revenue. Since the quarterly price of natural gas is around 37% higher, year over year, this could pull up Chesapeake Energy’s production revenue, assuming all things equal, by 12%.
But due to expected drop in the price of natural gas over the long run, the company has slowly reduced its natural gas operations. In 2014, the company estimates its natural gas production will inch down by 1%, year over year. Nonetheless, its natural gas operations are still likely to account for more than a third of its production revenue.
The recent developments in the natural gas market have benefited people, who invested in United States Natural Gas (NYSEMKT: UNG), a natural gas ETF. In the past several weeks, United States Natural Gas has outperformed the spot price of natural gas because the futures market shifted from Contango to Backwardation. Contango occurs when the prices of long term future contracts are above the prices of short term future contracts. When the market is in Contango, the price of this ETF tends to fall below the price of natural gas. But when the market shifts to Backwardation, in which long term future contracts are below short term future contracts, UNG tends to outperform natural gas. In the past several weeks, the futures market shifted to Backwardation — basically the market expects the price of natural gas to drop in the coming months. Therefore, investors of UNG didn’t suffer as much as natural gas investors did as indicated in the chart below.
Source: EIA and Google finance
In the chart above, you can see that UNG has outperformed the price of natural gas mainly in the past several weeks. If the future markets remain in Backwardation, and if the price of natural gas continues to fall when UNG rolls over its future contracts (the ETF sells its near future contract and buys its next month’s future contract in order to maintain its position of near month natural gas future contract), the price of UNG will remain above the price of natural gas.
Natural gas is likely to fall further in the coming months. Moreover, the elevated prices of natural gas are likely to cut down the demand for natural gas in the power sector, which could also reduce the total demand for natural gas during 2014. Natural gas producers such as Chesapeake Energy will benefit from the recovery of natural gas in the first quarter of 2014, but down the line the expected decline in demand for this commodity could slash natural gas producers’ revenues.
For further Reading see:
- Why Coal Isn’t Going Anywhere
- Is Chesapeake walking towards the right path?
- Why the Recent Rally in Natural Gas won’t help XOM
Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.