There’s an old saying that goes something like this: “In the valley of the blind, the ‘one-eyed man’ is king.”
If you seriously consider what I’m about to show you, this old saying could well ring true for your investment portfolio at the end of this year. Perhaps even before. Let me explain…
At roughly $2.41 per million Btu, U.S. natural gas prices are in the dumpster. The truth is, they’ve been declining for years. But the recent shale gas boom accelerated their fall. Now they’re the lowest they’ve been in over a decade.
If it gets any cheaper, the companies that supply it will be paying you to take it. You see, they have a huge problem.
They have to keep producing in order to generate revenue, even in the face of declining prices. The problem here in the United States is that supply exceeds demand by a wide margin. And it’s getting wider all the time.
Why? Stores of natural gas at record levels… A mild winter… New wells coming online every month…
No wonder it’s eviscerating shares of explorers and producers. Take a look at the six-month chart for Chesapeake Energy Corporation (NYSE: CHK), for instance.
It looks like the first big drop on a roller-coaster. Shares are off 38% since last July.
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By Marin Katusa, Chief Energy Investment Strategist
I recently gave an interview on Business News Network (BNN) about natural gas. BNN is Canada’s largest news channel dedicated exclusively to business and financial news, so all kinds of market players rely on BNN to provide them with comprehensive coverage of global market activity from a Canadian perspective. Like similar news channels in the US, BNN intersperses real-time news coverage with economic forecasting and analysis, company profiles, and tips for personal finance.
I have been interviewed on BNN numerous times over the last five years, quizzed on the impacts of fracking, the forecast for uranium following Fukushima, the potential of new frontier oil regions, and the future for coal. This time, the topic was “Five Tips for Natural Gas Investors.” You can watch the interview if you want; I highly recommend it – the education is worth the time.
On-air interviews are usually pretty speedy affairs, so my BNN interview didn’t give me enough time to discuss each point in depth. The Dispatch gives me that opportunity, so here are my five tips for natural gas investors in a bit more detail.
1. Watch for Looming Reserve Writedowns
A resource estimate is a geologic best guess of how much of a commodity exists within a particular deposit, be it ounces of gold, barrels of oil, or cubic feet of natural gas. A geologist gleans information about the deposit’s size and grade from drilling results and then creates a statistical model of the deposit. From that model he or she can estimate the commodity count.
However, the amount in the ground is not the amount that can be produced. That’s where the reserve estimate comes in. Reserves are an estimate of the amount of a commodity within a deposit that can be extracted economically, which means reserves are a whittled-down subset of total resources. That whittling down process has two steps. First, geologic and technologic factors determine a resource’s recovery rate, reducing the resource to the parts that are “technically recoverable.” Then, economic considerations further reduce the resource to only the bits that are “economically recoverable.”
With natural gas, the advent of horizontal drilling and multi-stage fracturing altered the first parameter dramatically, ballooning North America’s technically recoverable gas resources to many times their earlier volume. And while gas prices held, reserves counts ballooned too.
The key bit there was “while gas prices held” – that honeymoon is over. Natural gas prices in North America have declined roughly 35% this year and are down approximately 60% over the last 12 months. Compared to the unsustainable highs reached prior to the recession, gas prices have fallen more than 80%.
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By James Hamilton
Joseph P. Kennedy II, former Congressional Representative from Massachusetts, and founder, chairman, and president of Citizens Energy Corporation, has a proposal to make energy affordable for all. All we have to do, Kennedy claims, is “bar pure oil speculators entirely from commodity exchanges in the United States.”
Writing in the New York Times last week, Joseph Kennedy (D-MA) explained why he believes that speculators are responsible for the high price that we currently have to pay for oil:
Today, speculators dominate the trading of oil futures. According to Congressional testimony by the commodities specialist Michael W. Masters in 2009, the oil futures markets routinely trade more than one billion barrels of oil per day. Given that the entire world produces only around 85 million actual “wet” barrels a day, this means that more than 90 percent of trading involves speculators’ exchanging “paper” barrels with one another.
It’s true that most buyers of futures contracts don’t actually want to take physical delivery of oil. If I buy the contract at some date, I usually plan on selling the contract back to somebody else at a later date, so that I leave the market with a cash profit or loss but no physical oil. But remember that for every buyer of a futures contract, there is a seller. The person who sold the initial contract to me also likely wants to buy out of the contract at some later date. I buy and he sells at the initial contract date, he buys and I sell at a later date. One of us leaves the market with a cash profit, the other with a cash loss, and neither of us ever obtains any physical oil.
Let’s take a look, for example, at NYMEX trading in the May crude oil futures contract. A single contract, if held to maturity, would require the seller to deliver 1,000 barrels of oil in Cushing, OK some time in the month of May. Last Friday, 227,000 contracts were traded corresponding to 227 million barrels of oil, which is indeed a large multiple of daily production. But it is worth noting that at the end of Friday, total open interest– the number of contracts people actually held as of the end of the day– was only 128,000 contracts, much smaller than the total number of trades during the day, and not much changed from the total open interest as of the end of Thursday. Many of the traders who bought a contract on Friday turned around and sold that same contract later in the day. If the purchase in the morning is argued to have driven the price up, one would think that the sale in the afternoon would bring the price back down. It is unclear by what mechanism Representative Kennedy maintains that the combined effect of a purchase and subsequent sale produces any net effect on the price. But the only way he gets big numbers like this is to count the purchase and subsequent sale of the same contract by the same person as two different trades.
It’s also worth noting that on that same day, there were 146,000 May natural gas contracts traded, which if held to maturity would call for delivery of natural gas at Henry Hub in Louisiana. A single contract represents about 10 million cubic feet, so Kennedy’s calculations would invite us to compare the 1,146 billion cubic feet of “paper” natural gas traded on Friday with the total of 78 billion cubic feet of natural gas that the U.S. physically produced on an average each day in 2011. Once again, the vast majority of Friday’s natural gas futures trades were matched by an offsetting trade during the same day so as to have little effect on end-of-day open interest.
By what mysterious process can all this within-day buying and selling of “paper” energy be the factor that is responsible for both a price of oil in excess of $100/barrel and a price of natural gas at record lows below $2 per thousand cubic feet? I suspect the reason that Kennedy does not explain the details to us is because he does not have a clue himself.
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By Sumit Roy
The volatile WTI-Brent spread fell to multimonth lows, but surging production in the U.S. makes further narrowing challenging.
The Department of Energy reported this morning that in the week ending April 13, U.S. crude oil inventories increased by 3.9 million barrels, gasoline inventories decreased by 3.7 million barrels, distillate inventories decreased by 2.9 million barrels and total petroleum inventories decreased by 2.2 million barrels.
As expected, Brent prices continued to drift lower over the past week after breaking below the key $121 support level amid economic concerns and receding Iranian tensions. But in an interesting twist, WTI prices actually rose in the period.
The highly volatile spread between the two benchmarks narrowed to $14 from $17.50 last week and more than $20 at the beginning of the month. That puts it at the smallest level since Feb. 1.
The catalyst for this latest move in the spread was news that the operators of the Seaway Pipeline plan to reverse its flows earlier than expected — at the end of May, rather than June 1.
As we’ve written about in the past, the Seaway Pipeline was designed to send crude oil from the Gulf Coast to Cushing, Okla. But surging production in Canada and the U.S. Midwest has created a glut of crude in the region, depressing prices for local benchmarks such as WTI.
To reduce the gap between crude such as WTI and global benchmarks such as Brent, transportation capacity out of the Midwest needs to be increased. The reversal of the Seaway Pipeline — after which crude will flow from Cushing to the Gulf Coast — satisfies that need.
About 150 Kbbl/d of the pipeline’s capacity is set to be reversed late next month, while another 250 Kbbl/d may be reversed by early 2013.
Yet while the reversal of Seaway is a step in the right direction, the market anticipates it alone will not alleviate the Cushing glut completely. Still-wide spreads between WTI and Brent across the futures curve is evidence of that.
Rapidly increasing output in the Midwest and Canada necessitates steady increases in transportation capacity. Declining demand across the United States makes the supply and demand balance even more lopsided.
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“There is no life I know to compare with pure imagination. Living there, you’ll be free if you truly wish to be.”
– Willy Wonka
Chock another one up to the “let’s look like we’re doing something” category …
Suppose all 5th grade teachers at a given elementary school give their students ample amounts of candy before recess each day. This sugar high has led to wilder children on the playground. It has also emboldened the kids to act more dangerously as their risk-taking is near perfectly correlation with their classroom popularity. Taken together, the now rowdier mob of children has led to an increased number of serious injuries on the playground. And pretend for a moment that the rest of the student body is responsible for the hospital bills of these injured 5th graders. And pretend that prior to the teacher’s decision to sugar-up her students before recess the rate of injury was insubstantial. What might they do to mitigate the increased cost the public must pay for the hospital bill?
Easy. Lower the heights of the playground equipment and pay new playground police to monitor the situation closely. But don’t alter the pre-recess candy supply (maybe even increase the supply if the kids begin to look sluggish now that the playground equipment isn’t as inviting …)
President Obama is talking tough – he’s going to crack down on the problem that’s driving gasoline prices beyond tolerable levels. He’s going to crack down on those wretched speculators.
Obama is urging the CFTC use its clout to get tougher on those trading in the crude oil futures market. Specifically, he wants to see higher margin rates per contract and wants them to enact some form of position limits to mitigate any abnormally large long positions that could serve to manipulate crude prices higher.
Ted Butler would be proud. [If you don’t know Ted, he’s been all over the CME and COMEX and the regulators to rain down on such large short positions that are allegedly manipulating precious metals’ prices lower. It will be interesting to see if this do-something attitude being applied to the crude oil market will translate to the precious metals et al.]
All that said, here’s a short list often used on a day-to-day basis to explain the fluctuation in crude oil prices:
Geopolitical risk (e.g. what might result from butting heads with Iran)
Supply/demand changes (e.g. falling energy consumption in the US or depletion of existing well output rates or Saudis pumping overtime or supertankers running out of gas or …)
Inflation hedge (e.g. hold real assets in case prices soar as a result of the declining purchasing power of the US dollar—the currency in which most commodities are priced)
Broad-market risk appetite (e.g. commodities moving in line with “risk assets” driven by growth opimtimism)
Let me say this: speculation is a necessary and natural form of price discovery in the markets. It is this price discovery that sends signals to all market players, financial and real. The pricing system is the core of the market system and what makes capitalism the best and more efficient way to structure an economy. Period! End of story.
Yet politicos, through the ages, have attacked speculators as devious manipulators who are the cause of all ills economic. There is nothing new here; it’s the same tired scapegoat rhetoric.
Granted, there are speculative premiums embedded in prices; that is a fact and will not change as long as you have actively traded markets. Sometimes these premiums will be out of line, and those betting the wrong way will be punished by Mr. Market. But over time the real supply/demand dynamics will rule the day. Not speculation. Though I am not a big believer in so-called equilibrium, I do believe prices will trend toward some supply and demand equilibrium over the longer term. It’s true for oil, wheat, corn and every actively traded commodity. It has always been that way. This doesn’t mean markets or market mechanisms are perfect. They are not. And it doesn’t mean market efficiency can’t be improved. It doesn’t mean politically-protected con-artists—read Jon Corzine—should not be thrown in jail forever.
Down here in Florida we are represented in the Senate by Republican Marco Rubio and Democrat Bill Nelson. Marco is good, but not perfect. Bill isn’t so good. In fact, he recently delivered the government’s preferred approach to crude speculators in an interview with CNN where he promised these recently proposed efforts were not “political”. He then passed around a YouTube link to that interview. Here is the interview with Mr. Nelson if you can sit through it without a barf-bag at your side: http://youtu.be/Rz3kysPnudU
I felt compelled to write him.
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