Raymond James’ Energy "Stat of the Week"
What Does the Recent Bearish Gas Storage Number Mean to Energy Investors?
Last week, the U.S. Department of Energy (DOE) reported an extremely bearish U.S. Gas storage injection.
Specifically, the U.S. injected 108 Bcf versus our estimate of 85 Bcf and the Street’s estimate of a 90 Bcf injection. After adjusting for weather differences, this gas storage injection implies that U.S. gas supply/demand has recently changed from nearly 2 Bcf per day tighter than last year to 3-½ Bcf per day looser than last year. Frankly, the abrupt magnitude of this apparent shift in U.S. gas supply/demand
has left us scratching our heads wondering how could U.S. gas supply/demand possibly change that quickly.
When searching for explanations of this sudden shift, the most obvious answer is that it is a bad number that will likely be revised over the coming weeks.
That being said, we have to assume for now that the number is accurate. Assuming the number is correct, there were a couple of different issues that week that could have artificially inflated the gas storage number. First, it was a holiday week when many industrial consumers shut down operations. While we try to correct for this factor in our estimates, it is difficult to get a handle on the exact amount of demand lost due to the holiday. Secondly, it was one of the mildest weather weeks that we have seen in years. We have noticed
that our weather correction factors at the extreme ends of the weather spectrum (for both exceptionally hot and exceptionally cool weather) tend to have significant error associated with them. While the holiday impact and the weather impact were possible explanations, the only real logical explanation that we came up with is the fact that the price spreads between the near-month natural gas prices and the winter-month natural gas prices were at all-time record highs. In fact, the steep contango has created an extraordinary incentive to put gas in storage today and sell at a price nearly double today’s in just three months. In other words, the current gas storage price arbitrage opportunity is unprecedented.
What does this mean for near-term natural gas prices?
Again, assuming that last week’s storage number is accurate, it now appears we will test the limits of U.S. gas storage capacity over the next eight weeks. Given that we have limited storage capacity, the gas market is facing what most analysts call “gas on gas” competition. This is the phenomenon where limited gas storage capacity forces gas producers to shut in production. If last week’s number
represents a trend, then U.S. producers would need to shut in about 10% of their production to rebalance the system over the next two months.
The production curtailments can be driven by either lower gas prices (i.e., prices fall enough to encourage producers to shut in gas) or higher pipeline pressures (i.e., wellhead pressures are too low for the gas to flow into the pipeline system). We are already seeing price induced curtailments in certain parts of the Rockies (Wyoming) where gas prices have become extremely volatile, bouncing around daily between mid $2 and mid $4 per Mcf as all storage capacity has become full in that particular region. Some believe that this implies that spot gas would need to fall to cash costs in other areas before operators would begin to shut in.
The reality is that many begin shutting in before reaching cash costs, recognizing that they could likely sell that gas three months from now at much higher prices. While less visible, pipeline pressure induced curtailments will also likely begin to occur over the coming weeks. Our view is that it will be a combination of both price induced shut-ins as well as pressure induced shut-ins that allow the system to rebalance over the coming months.
What does this mean for 2007 natural gas prices?
The extent to which this current U.S. gas supply/demand imbalance will impact 2007 natural gas prices depends on exactly how much gas storage capacity will be available. Simply put, if maximum storage capacity is 3.5 Tcf or less, then our outlook for 2007 will continue to remain very robust, regardless of shortterm gas prices. If, on the other hand, we have 3.7 Tcf or higher of storage capacity, then additional large storage injections will leave a gas storage overhang that will negatively impact our 2007 natural gas outlook.
Unfortunately, we (and everyone else) do not know exactly how much usable storage capacity exists. What we do know is that the most amount of working gas that we have ever put into storage is slightly above 3.4 Tcf and we have not added any meaningful storage capacity. Our view has been and continues to be that we will max out at about 3.5 Tcf for storage. If we are correct, then the following table shows our guess at
the winter U.S. gas supply/demand and estimates winter ending gas storage. Our numbers suggest if we end October with around 3.5 Tcf in storage, then we will begin next summer’s injections season at around 1.3 Tcf of storage.
Of course, if actual storage capacity is 3.7 Tcf, then the analysis above would likely result in March ending storage closer to 1.5 Tcf. While our estimate of 1.3 Tcf of winter-ending storage is higher than the long-term average of almost 1.2 Tcf it would be meaningfully lower than the 1.7 Tcf where we ended last season. More importantly, we think the gas
market would be tight enough to support natural gas prices back up into the $8 to $12 per Mcf range (assuming crude averages around $70 per barrel).
What does this mean for Energy Stocks?
Clearly, our bullish outlook for gas prices this summer has been one of the more contrarian calls that we have ever made. As we have met with investors over the summer, there has been overwhelming consensus that natural gas prices would collapse in the September/October time frame. Because of this bearish stock market sentiment, we believed that the stock market was already discounting a collapse of natural gas prices. However, what we didn’t anticipate was a complete commodity meltdown, with oil going from ~$78 to ~$63/ bbl, which, combined with the weakness in natural gas, led to a sharp pullback in the energy complex.
At this point, we are not ready to throw in the towel on our bullish $10 Mcf 2007 natural gas forecast. The two reasons for this are: (1) we don’t think the huge storage injection seen last week is repeatable, and (2) even if we are wrong on #1, we think storage capacity will max out at around 3.5 Tcf, not 3.7 Tcf. Accordingly, we remain bullish on our 2007 outlook, recognizing that there is substantial near-term uncertainty surrounding both natural gas and crude prices. In other words, we don’t think we have seen enough data to either pound the table or pull the plug yet. We do know that there is a substantial amount of capital sitting on the sidelines waiting for the opportune time to enter the group. If the gas storage numbers turn more bullish over the coming weeks (as we expect them to do) and the overall commodity melt-down exhausts itself over the coming weeks, then this group is poised for excellent performance through the winter. In the meantime, expect extreme volatility over the coming weeks as more data provides more clarity. |
