Despite Monday’s spike, there is considerable space for natural gas to rally higher, should investors return to a fundamentals-based assessment of the commodity. According to my Fair Price Model, natural gas is still trading at a 23% undervaluation versus a Fair Price of $2.32/MMBTU based on current inventories alone. This undervaluation contracts in the weeks to months ahead as initially the storage surplus rises due to generally warmer-than-normal March temperatures, falling to around $2.25/MMBTU by early April. Thereafter, the Fair Price rallies towards $2.50/MMBTU over the summer as the supply/demand imbalance tightens, though this merely keeps pace with the seasonal rebound in futures pricing. Over the full 8 month period for which I publish projections, natural gas is undervalued by an average of 16%. However, these projections are based on the current supply/demand imbalance and do not fully account for a potential dramatic tightening should production fall sharply in response to the sell-off in oil prices, meaning these late-summer numbers may be too conservative.
Adding to the potential for a rally, the Commodity Futures and Trading Commission (CFTC) continues to report an historic surplus of short holdings. Based on the latest data, 435,554 contracts–or 75% of open positions–are held short, down from a February peak of 505,119 contracts, but still up a massive 365,858 contracts or 521% year-over-year, as shown in the Figure to the right. CFTC-Reported Natural Gas Long & Short Positions
This set-up for a massive short-squeeze has been in place all winter but went unfulfilled due to record warmth. However, the ongoing overcrowded short trade could boost a fundamentally-driven rally this spring and summer as these shorts, especially those late to the party, are forced to exit their positions en masse. For now, I am maintaining an upside price target $2.10/MMBTU, representing 18% upside from current levels, though if oil holds under $35/barrel, this could wind up being conservative. I remain long the sector and feel that natural gas should be bought on temperature-driven dips.
While natural gas bounced Monday, oil most assuredly did not. The dynamics of coronavirus-induced demand shock followed by the stunning collapse of the OPEC-Russia alliance and emerging price war have been discussed at length here and elsewhere, so I will not rehash. Regardless, in response to two of the world’s largest oil producers pledging to ratchet up production in the face of falling demand to take on each other–and the US shale industry–oil prices crashed on Monday. WTI tumbled a stunning $10.15 or 24.6% to $31.13/MMBTU after briefly dropping as low as $27/barrel in overnight electronic trading. Brent fell $10.91 to $34.36/barrel. The percentage losses were both the largest since the early days of the Gulf War in 1991 and the settlements were the lowest in 4 years. While oil is bouncing overnight into Tuesday morning to over $33/barrel, it is still too early to call a bottom here. Goldman Sachs warns of the potential for WTI settling into the low $20s/barrel in a worst case scenario of a prolonged price war. However, I do feel that OPEC and Saudi Arabia will feel the pressure and that both will come to the negotiating table sooner rather than later. Additionally, the drop under $40/barrel–much less $30/barrel–will result in a sudden and irreversible decline in US drilling activity with US output likely falling under 12 MMbbls/day by this summer, and potentially considerably lower if discounted oil prices stick around into the summer. At this time, I am targeting upside of $45/barrel over the next several months, though I am not buying at these levels.
6:00 AM EDT, Wednesday, March 11, 2020
The natural gas short squeeze is on…finally. The commodity benefited from back-to-back bits of news that benefited both the near- and long-term prospects for gas, sending buyers streaming back in and shorts that had overstayed their welcome scrambling to get out.
First came the weekend’s news of an all-out oil price war between Saudi Arabia and Russia, ostensibly to maintain market share, but at least indirectly to drive high-cost US shale producers out of the sector. Following an initial bizarre reaction that send natural gas prices down to 4-year lows Sunday evening, investors re-evaluated the prospect this story through the lens of a sharp cutback in US associated gas production. The commodity rapidly erased its losses Monday morning and finished with 4% gain. Then the ECMWF ENS near-term model cooled considerably overnight Monday as an area of low pressure over Hudson Bay could allow unseasonably cool temperatures to overspread the major population centers of the Midwest and Northeast during the second half of March. This, plus follow-through from the collapse in oil and a still massively overcrowded short trade, sent prices soaring on Tuesday. The front-month April 2020 contract spiked 16 cents or 8.9% to settle at $1.94/MMBTU. It was the largest single-session gain since January 14, 2019 and the highest settlement since February 19. As the Figure to the right shows, natural gas futures prices are now above $2.00/MMBTU in all but the April and May contracts with the commodity topping $2.35/MMBTU by November.
Since prices reached as low as $1.61/MMBTU in Sunday evening electronic trading, natural gas is up a massive 20% in just two sessions. This is putting in dire jeopardy something that most investors had felt was a given: the longest streak of sub-$2.00/MMBTU prices since 2000. The current record, based on NYMEX data, is the 38 straight days back in April 2016. Through yesterday, this year’s streak stands at 36 straight, as the Figure to the right shows. While I would not be surprised to see natural gas prices pull back some as profit-takers step up, even a small amount of additional momentum, triggered by either further near-term cooling, a larger-than-expected storage withdrawal in Thursday’s EIA storage report, or renewed selling in oil, could vault natural gas above $2.00/MMBTU and snap the streak just shy of this century’s record.
Long-term, natural gas remains steeply undervalued, even with the spike. Based on current inventories alone, this undervaluation stands at 16% versus a Fair Price of $2.31/MMBTU.
Even for the full 8-month period for which I issue storage projections, the commodity is undervalued by an average of 9.5%, as shown in the Figure to the right. Which such a sharp upturn in such a short period of time and with the storage surplus versus the 5-year average topping 2020 highs today, I would not be surprised to see a near-term pullback, perhaps back into the $1.80-$1.85/MMBTU range. I feel that such a dip should be cautiously bought though, do understand, the easy money was made on this early-week spike and moving forward gains will likely be choppier and a bit of a grind. I am maintaining a $2.15/MMBTU upside price target.
My posts are my opinion. Always trade at your own risk.
