$4 Natural Gas

Jim Brown
 
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Natural gas futures spiked over $4 on Wednesday as short covering continues. Gas was heavily shorted in expectations of the normal spring decline but storm after storm has pushed sentiment higher and hedgers are being forced to cover.

Never say never. Four dollar gas was not supposed to happen for a long time given the record production each month and the roughly 2,400 new wells completed each month. The track for increasing supplies is very obvious. Ironic in fact since analysts in 2005 were predicting the peak gas. Supplies had declined for four years and conventional gas reserves were dwindling. Suddenly horizontal drilling and massive fracking operations with 3-4 million gallons of water per well changed the face of natural gas production. The Barnett Shale under Fort Worth and Dallas proved to be a fertile proving ground for shale gas drilling techniques. Your neighborhood was not complete if it didn't have a gas well in the park.

Gas Production Chart

Fast forward to 2013 and there are only 413 active gas rigs and right at a 13 year low. Those rigs have mastered the art of drilling a horizontal gas well in an average of 17 days. With the arrival of multi-pad drilling they simply move the rig over a few feet and drill another one with the lateral going in a different direction. The lack of need to physically move the rig several miles between each well drilled has dramatically increased the number of wells that can be drilled in a year.

The 1,324 active oil rigs are producing substantial amounts of associated gas along with the oil. In many cases the shale oil fields have a large percentage of gas with the oil. Just because the rig is classified as drilling for oil does not mean they are not going to produce gas as well.

The weekly late winter storms over the last month have caused a significant increase in gas demand. According to the EIA U.S. consumption was up +26.40% last week over the same week in 2012. Residential and commercial demand was up a whopping +101.02% over year ago levels. Demand was due to the waves of cold weather sweeping across the Northeast. Demand was also increased as a result of multiple nuclear power stations being offline for extended maintenance during what is normally a low demand month.

Even with the higher demand the amount of gas withdrawn from storage was only -62 Bcf leaving 1,876 Bcf in storage. That is 162 Bcf above the five year average so there is NO apparent reason for gas prices to be soaring. The chart below shows the normal ranges for this time of year and the current blue line is right in the middle of the averages.

Working Gas Storage Chart

The surge in gas prices is going to cause producers that had constrained production because of low prices to open those valves and let it flow. It will probably start another flurry of well completions for wells previously drilled but left uncompleted because of low prices. There are a significant number of wells in the Marcellus Shale that are completed and ready to go but the feeder pipelines have not been completed. That caused a significant increase in production late in 2012 after two major pipelines were connected. There will be another boost in April and May as more pipelines are completed.

I believe the majority of the price spike we have seen in the last month has been from shorts covering. Hedgers and speculators were expecting the price to decline. When the opposite occurred it forced those positions to be closed. When prices stalled at $3.90 last week I believe many of those positions were restarted and today's spike was yet another covering cycle. Aggressive shorts are their own worst enemy when the market turns against them. The short, cover, short, cover cycle is painful for those trying to initiate the positions.

Gas at $4 is the switching point for dual fuel coal and gas power plants. When gas moves over $4 it is cheaper for them to burn coal and that reduces gas demand. A penny or two is not going to make a lot of difference but any further gains in gas prices is going to force that gas to coal switch.

Gas closed today at $4.07 with the inventory report due out tomorrow. If the draw from storage is less than expected we could see a quick end to this price cycle. There is another storm working its way across the U.S. but we should be at the end of the cold weather.

The weekly EIA inventory numbers for crude oil showed an increase of +3.3 million barrels to 385.9 million. That is only 1.4 million below a 22 year high set last June at 387.3 million. The surge in inventory came from a monster increase in imports of +841,000 bpd or 5.9 million barrels for the week. Refinery demand rose +364,000 bpd but it was not enough to compensate for the increased supply. U.S. production was flat at 7.15 mbpd. That is -1.0 mbpd below imports at 8.16 mbpd but by year end I expect the production numbers to exceed imports on average. With rising production of light crude in the U.S. there is less incentive to import sour crude from overseas.

Distillates declined a whopping -4.5 million barrels. Most of this was due to a surge in heating oil sales in the Northeast. Distillate demand rose +642,000 bpd and more than compensated for an increase in imports of +157,000 bpd. Some analysts theorized the increase in distillate demand was due to diesel trucks moving more goods but we won't know for sure until the cold weather abates and see if the numbers remain the same. Low sulfur fuel oil declined from 96.1 million barrels to 93.2 million.

Gasoline inventories continued to decline as refiners let their winter blends deplete to make room for gasoline blended for summer use. Gasoline demand rose only slightly by +75,000 bpd.

Refinery utilization spiked to 85.7% from 83.5%. Refiners are still going through their spring maintenance cycle so the utilization numbers will remain volatile for the next few weeks. With the sharp drop in distillates we could be seeing a short term spurt in refining to rebuild those stocks. Distillate inventories are still about 15% below year ago levels.

Inventory Snapshot

Crude Oil Inventory Chart

Gasoline Inventory Chart

Distillate Inventory Chart

In 2012 the U.S. imported an average of 8.5 mbpd of crude oil. That was the lowest rate since 1997. Imports peaked in 2005 at 10.1 mbpd. Over the last eight weeks the average imported oil has declined to 7.63 mbpd. That compares to current U.S. production of 7.15 mbpd. With U.S. production expected to increase 700,000 to 1.0 mbpd by the end of 2013 we should be importing less than we are producing for the first time in more than 25 years. Imports have fallen the most to the Gulf Coast. In the four weeks ended on March 1st Gulf imports were less than 3.4 mbpd and that was the lowest since 1992.

With the increased production in Texas and additional pipeline capacity from the Midwest to the Gulf this is the area where imports are going to suffer. West coast and Northeastern refineries are suffering from a lack of pipeline capacity for the cheap crude produced in the Midwest and Bakken. The ocean coasts are forced to buy imported waterborne crude at Brent prices. There are efforts underway to solve this problem. Refiners are buying huge numbers of rail cars to transport cheap Bakken crude across country to benefit from the lower prices.

Two new refineries are under construction in North Dakota. The Dakota Prairie refinery will be 20,000 bpd and is expected to be completed in 20 months. This refinery will concentrate on diesel fuel to power the massive number of trucks and rigs currently operating in the Bakken. The Trenton Diesel refinery, also 20,000 bpd, is also planned to focus on diesel fuels, light gas oil, naphtha, kerosene and heavy fuel oil for the bunker fuel market.

Tesoro has a 60,000 bpd refinery near Bismarck. Their primary products are diesel, jet fuel, heavy fuel oils and LPG.

Chevron

Chevron (CVX) finally caved into pressure to release data on the recently drilled Coronado well in the Gulf. After the recent news on the Shenandoah well with 1,000 feet of net oil pay in very porous sands by Conoco and partners, the pressure was on for Chevron to release data. Chevron said the well was drilled to 31,866 feet in 6,127 feet of water. Chevron owns 40%, Conoco 35%, Anadarko 15% and Venari Offshore 10%. Chevron has not yet released official reserve estimates but was forced to say something after Venari let the cat out of the bag last week that the well was a big discovery. Chevron has three big projects in the Gulf including Jack-St Malo, Big Foot and Tubular Bells. All should begin production in 2014 with full production rates just under 300,000 bpd. 2014 is going to be a monster year for Chevron and the rest of the decade just keeps getting better with the massive LNG projects in Australia coming online after 2015.

Market

The market recovered from a triple digit dip at the open to see the Nasdaq return to positive territory and the S&P almost do the same. The Dow gave back -33 points.

The resistance at this level is huge. If it were not for the quarter end window dressing I suspect the outcome today would have been a lot different.

The economic calendar for Thursday, the last day of the week and quarter, could be a problem. The GDP, ISM and Kansas Fed Survey could all disappoint. If by chance they surprised instead we could see a spike over resistance but it could be brief.

Economic Calendar

Even though the market recovered most of its losses today the resistance held firm. Once the economic reports are out of the way in the morning the volume is going to die and fund managers are going to pack it in for the weekend. They have done all they could to hold the market up for quarter end and the three day weekend is going to be calling them home.

We are seeing distribution at these levels. The number of individual stocks making new highs is slowing. Quite a few of the winners over the last couple of weeks are beginning to test support. Once the quarter end fund flows are behind us I expect the markets to weaken. Earnings expectations are poor and the market hype over new highs is beginning to fade.

The four month rally could end with a strong "sell in May" seasonal cycle. The global economy is weak. The dollar is strong. The U.S. economy is weak and after sequestration it could be weaker. The only positive for the market is the QE program and even that support may have run its course. The analysts are more concerned with predicting an early end to QE than projecting QE into 2015 as the Fed suggests. On the plus side for QE two Fed heads were making comments today saying Fed policy was not weak enough. That is a counterbalance to those analysts worried about a end to QE later in 2013.

I would be cautious about new longs in the market until we see a dip.

Jim Brown

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