Four Things You Should Know About Natural Gas

In our April issue of the Casey Energy Speculator, we concluded that natural gas prices in North America have several bullish factors working in their favor.

This conclusion was based on a demand squeeze caused by declining North American gas reserves, exacerbated by the increase in consumption by Canadian oil sand operators.

In the months ahead, we'll bring our readers' attention to a variety of opportunities to profit from the resurgence in gas. But for this month, we thought it would be useful to set the stage by pointing out four things you need to know (and may not) about natural gas.

1. Canada and the U.S. Natural Gas Markets Can Take Different Paths

Although their day in the sun is coming fast, the share prices of Canadian natural gas companies have taken a hit over the past year. This was largely due to the rule changes in Canadian laws affecting the tax status of the Income Trusts. These trusts used to avoid corporate taxes by distributing most of their income to shareholders directly. Now, trusts will face corporate taxes. The change prompted a sector-wide sell-off.

In the U.S., however, gas companies have been on a tear. The market-weighted Dow Jones Oil and Gas Producers index of 373 publicly traded U.S. companies, has gained 33% in the past two years. The other key components of the U.S. natural gas markets, exploration, production, and equipment/service/distribution have also posted strong gains.

The important lesson here is that, unlike oil, the factors affecting natural gas tend to be much more localized. In the case of the Canadian issues, the success of the Income Trusts created hungry demand for producing gas companies to keep the pipeline full and the distributions flowing. That created something of a market anomaly that was quickly and sharply corrected by the change in legislation.

As is so often the case, the Canadian sector is almost certainly oversold, with excellent companies now going at fire sale prices.

2. Weekly Supply/Demand Data Is a Poor Indicator of Market Trends

Equity markets tend to overreact to the weekly supply/demand data released by the Energy Information Administration (EIA). Even by the EIA's own admission, the data released every Thursday can be – and often is – revised. Therefore, a longer-term perspective on the data is necessary: Only by looking at the numbers in the context of months rather than weeks can a sense of the market trend be developed.

As an investor in this sector, it's important to have a longer-term perspective. And the long-term trend is our friend. Simply, if you're on board with the inevitability of rising gas prices, you can use any share weakness triggered by a Thursday EIA report showing an unexpected fall-off in demand, or higher-than-expected supply, to add to stock positions.

3. Oil Prices Influence Natural Gas Prices... But Usually Only After a Time Lag

Despite perceptions to the contrary, the correlation between the price of natural gas and oil is not immediate. For one, natural gas prices are not nearly as influenced by geopolitics as world oil markets are. So, a bomb going off in a Saudi Arabian refinery may send oil traders scampering for cover... but would be of only modest interest to those on the natural gas desk.

That's largely because, as mentioned a moment ago, natural gas is more of a regional market, and by region, we mean that it differs from continent to continent, even from country to country and state to state.

Even so, in "The Relationship Between Crude Oil and Natural Gas Prices" released by EIA, Frederick L. Joutz shows a significant correlation between natural gas prices and those of oil. The study makes a good case that when a temporary spike of at least 20% occurs in the price of WTI crude (West Texas Intermediate crude oil), it has a 5% contemporaneous impact on natural gas prices.

But over time, the impact can be much more significant. Our studies have shown that, all things being equal, a sustained price shock of 20% or more in the WTI leads to a 16% increase in the Henry Hub quoted price for natural gas one year out. As oil prices continue to move upwards, natural gas prices will also; but there is a definite lag.

4. Natural Gas Futures Are a Key Driver of Gas Prices

Each day something on the order of $7.2 billion in natural gas contracts trade hands on futures markets, with open interest at any given time closer to $60 billion. There is little question, therefore, that futures markets are an important driver.

For instance, the natural gas futures market may influence how much gas an operator produces under a contract and how much they submit to storage. Paying attention to the pricing of futures markets can, therefore, be a strong indicator of whether you as an investor should buy into a natural gas-weighted stock issue today – or perhaps wait a few months.

Middlemen in the gas supply chain watch spot and futures prices closely. When futures prices are higher than spot, they buy cheap on the spot market (either from gas producers or other traders) and sell forward at higher prices, locking in a mark-up. But forward sellers then need to store the gas for a few months, either in a facility they own, or in a third-party facility that rents space. Thus, when futures prices are significantly higher than spot, gas in storage grows.

The flip side is that when spot prices rise above futures prices (usually during times of high demand, like the winter heating season), gas owners will sell everything they have on the spot market. If you can get a good price now, why pay storage costs?

Our Conclusion:

Old methods for evaluating significant changes and trends in prices are no longer good as stand-alone barometers. In addition, the notions that market efficiencies will largely determine a company's market valuation, and that every company pumps as much natural gas as it can, are no longer reliable.

In sum, a regional free-for-all is brewing. U.S. and Canadian gas consumers will be competing for a diminishing supply of natural gas. Prices could return to all-time highs. Bad news for people trying to heat their homes, but for gas producers it's a windfall.

Good investing,

Casey Research