Flash Alert: Natural Gas Rally

In the September 2 issue of The Energy Strategist, The Gas Puzzle, I took another look at natural gas, perhaps the most controversial commodity market around. Views on the future path of natural gas vary widely; some analysts forecast a price plunge to below $2 per million British thermal units (MMBtu), while a smaller cadre of bulls sees prices reaching $6 per MMBtu at some point during the first half of 2010.

I fall into the latter camp and am looking for gas prices to rally considerably into early 2010. As I explained in The Gas Puzzle, most of the weakness is concentrated in the front-month futures contract, i.e. the price of gas for delivery before the onset of winter heating season. Futures due for expiry early in 2010 are trading above $5 per MMBtu.

The weakness in near-month futures primarily reflects traders’ jitters about the fact that US gas storage is likely to reach capacity before the end of injection season in early November. There are already reports that pipeline operators in parts of the US are requiring companies to feed less gas into the system because there’s simply nowhere to store it all.

However, in recent sessions near-month futures have soared and early 2010 futures have risen, albeit by a much smaller amount. I see a number of catalysts for the recent run-up in gas futures.

  • Short-covering. According to the most recent report from the Commodity Futures Trading Commission, non-commercial traders (speculators) are short about 31,000 natural gas contracts. because gas prices tend to find a seasonal low this time of year and gas prices are trading at depressed levels, it doesn’t take much of a catalyst to prompt traders to cover some shorts, forcing prices higher.
  • Goldman Sachs made positive comments. Investment bank Goldman Sachs (NYSE: GS) has a good record on timing commodity price swings and last week it made positive comments about gas. These arguments were almost identical to the bullish longer-term points I outlined in The Gas Puzzle.
  • A smaller-than-expected increase in stored gas. Last week’s storage report from the Energy Information Administration showed natural gas inventories building at a slightly lower-than-expected pace. This was the proximate catalyst for a late-week run-up in natural gas prices. Although storage levels are still excessive and will likely reach record levels, natural gas in storage increased at a slower pace in August than it did one year ago despite much milder summer weather. This suggests that industrial demand is picking up and the unprecedented decline in the US gas-directed rig count is filtering through into lower production of gas.
  • Better-than-expected industrial production figures.  The Federal Reserve reported this morning that industrial production rose 0.8 percent in August against expectations for a 0.6 percent increase. This is the second straight month of better-than-expected data. Industrial production is a good indicator of industrial demand for gas; today’s number suggests demand is already rising or will soon pick up.

While I suspect we’ve seen the low for gas in this cycle, near-month futures prices will remain volatile into early November because of continuing concerns about storage levels ahead of winter heating season.

As I noted in The Gas Puzzle, amid all the drama in near-month futures, futures due for expiry in early 2010 have been much quieter. In addition, stocks leveraged to natural gas prices have been among the best-performers in my coverage universe and have been outperforming oil-focused names of late. This was true even as near-month gas futures prices tumbled to seven-year lows.

The outperformance of gas-focused equities reflects the fact that traders are looking for gas prices to recover next year. The stock market tries to predict and discount future conditions, not react to short-term aberrations.

Focus on the gas-levered stocks in the TES Portfolios–highlighted here and here–to play evolving market conditions. Because they’ve performed extraordinarily well of late, I’m raising buy targets on the following three stocks:

  • Chesapeake Energy 4.5% Preferred D (NYSE: CHK D)–Buy @ 90
  • XTO Energy (NYSE: XTO)–Buy @ 50
  • Nabors Industries (NYSE: NBR)–Buy @ 23

Editor’s Note

The Energy Strategist is published twice per month, 24 times annually. That means that twice per year we take a one-week production break.

Your next regularly scheduled issue will be published a week from today, September 23. I’ll continue to monitor the energy markets and TES recommendations and issue Alerts as needed.

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