Winter 2017: Bulls and Bears in Natural Gas

Objective: Constructing a tradable portfolio of liquid NG products with a time horizon of six months or less.

Premise: Despite elevated domestic production, increased exports and power burns will result in less-than-normal winter storage inventories and induce a volatile pricing environment.

In addition to conventional supply and demand dynamics, natural gas prices continuously adjust to incorporate prevailing storage (temporal) and pipeline (locational) constraints. On the supply side, domestic shale gas production has increased substantially over the years and continues to validate the growth estimates in the second half of 2017. Recent increases in Haynesville Shale, Ohio, and Permian carried the momentum outside of the Northeast and total daily dry production rate currently stands at 72.7-73.5 Bcf/d. This rate will likely reach 75.5+ Bcf/d by Dec 2017. Canadian net imports also are expected to increase as production from Montney and Duvernay will need to locate consumers. Overall, the domestic supplies look robust and are expected to increase in the foreseeable future.

On the demand side, the largest single source of demand for natural gas comes from power generators. On 7/20/2017, we had the second-highest single-day burn at 42.75 Bcf/d, but moderate summer weather recently dampened EG demand. Among residential, commercial, and industrial customers, the industrial sector proved to be resilient and has shown increases from last year. I expect the industrial demand will continue to be strong for the rest of 2017. Apart from domestic consumptions, Mexican exports have also increased as their non-associated gas production reached a 15-year low amid country’s effort in modernizing the electric grid systems. Among all demand sources, the biggest growth lies in LNG exports. With increased export capacity at Sabine and upcoming export facilities [Cove Point (Q4 2017), Cameron (Q3-Q4 2018), Corpus Christi (2019), Freeport (2018-2019), and Elba Island (2019)] will continue to raise LNG demand and saturate the global LNG market. Timing is obviously up for a debate as many projects previously faced delays, but there is little doubt that increasing share of U.S. gas will find its way in the global LNG market.

Because supply and demand dynamics are so fluid, the line distinguishing cause and effect often gets blurry. For instance, increased production causes prices to drop, ceteris paribus; however, lower prices also disincentivize producers to produce. It’s an iterative process with many factors that are comingled to meet equilibria with prevailing constraints and opportunities. To better model the phenomena, full-blown simulations with dynamic temporal correlations/volatilities would be ideal, but it’s also “acceptable” to stress each variable one at a time. And given current supply and demand outlook, it’s reasonable to assume that we will end up with less than the typical inventory level of 3.8 Tcf-3.9 Tcf. If a colder-than-normal winter (or expectation) materializes, even with robust production, price spikes and/or elevations will likely occur during Q3 and Q4 2017. Given this premise, what kind of portfolio can be economically constructed to optimally capture the market volatility and price movements? To answer this, one must consider not only primary effects, but also secondary and tertiary effects of the aforementioned premise of bullish/volatile pricing scenarios.

I’ll discuss three methods of constructing a portfolio with tradable instruments without incurring exorbitant bid-ask spreads. Also, one needs to make sure the portfolio can be easily liquidated or hedged if adverse prices ensue. The first method is buying/selling outright contracts for specific maturity dates – while choosing the quantity, maturity, entry level of a specific contract are up for much discussion, the method itself is rather self-explanatory; hence no further comments are made here. The second method is buying either temporal spreads or locational spreads. For instance, given my purview of the storage outlook, I noticed the Oct ’17-Mar ’18 spread was relatively tight at $0.201 at the beginning of July. The spread has widened to $0.272 in the beginning of August and it stands at $0.235 (per NYMEX) as of 8/11/2017. The recent oscillations allowed market participants to generate alpha by trading in and out of this time spread. Another way to constructing a portfolio is using locational basis swaps. Certain paths tend to out/underperform given bullish environments, but this topic will not be covered here. Another way to create a portfolio to take advantage of pricing movements is derivatives. 25 delta risk reversal of March 2018 contract currently stands near +10%, which shows heightened risk aversion towards price rallies. For instance, on a historical basis, this risk reversal ranged from 1%-6%. Given such high call premiums, it would not be a prudent investment idea to purchase OTM calls. However, the steepened volatility skew offers a decent way to establish a bull spreads at reasonable net premiums. Also, selling OTM puts amid weather-driven events to finance the bull spreads can be one of the main objectives of establishing the portfolio. This method reminds me of the techniques used to create some successful subprime portfolios (e.g. selling underlying to finance long CDS position) and the disastrous London Whale trades (simplified: selling NA IG CDX to buy European single name HY CDS). Hence, it’s crucial to keep on a tight leash on the portfolio and market; and hedge and liquidate if adverse price movements exceed one’s preset risk tolerance. I suspect the opportunity for constructing a similar portfolio may exist in Q3 (depending on weather), but opportunities will not likely last for long.

Supply and demand dynamics and prices of tradable instruments are not simply the numbers to be analyzed and optimized in isolation, but such studies must be complemented by examining company-specific fundamentals such as CAPEX/hedging ratios/credit/cash flows/etc. Only then, one can better visualize plausible pricing environments. Lastly, it’s always astute to seek out views that are different than one’s own and try to understand reasons behind his/her opposing stance. One hedge fund manager with bearish natural gas fundamentals is Robert Raymond at RCH who described two bears (i.e. dry gas production (rigs) and associated gas) on CNBC last week.