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TFC Commodity Trading Forum

Natural Gas - The Big Short

February 22, 2011

When I (Gross) was a kid growing up in Western Pennsylvania, there was a patch of woods behind our house that my brother and I used to roam. With few other houses around, it was a secluded area. We built a makeshift cabin - if you could call it that - which provided a "spot" to spend dog day summer afternoons. I doubt anybody has been back there since, except possibly the odd hunter.

When I went home to visit my father last summer, I went back into the woods to visit our old spot. The cabin was long gone. What was there was even more surprising. A Natural Gas well. Somebody had found "our spot." Most likely because our spot sat more or less right in the middle of the Marcellus Shale, potentially the largest deposit of Natural Gas discovered in the United States - ever.

In just the last five years, new discoveries of natural gas in the US (like Marcellus) along with a new focus on "clean" energy have resulted in a spike in production. 308 new producing rigs were brought online in the "lower 48" between July 2009 and April 2010 - nearly a 50% increase. In 2010 alone, US Natural Gas production surged by 4.1% over the previous year. The production surge has been so overwhelming that it is testing storage and pipeline capacity limits. Bentek Energy reports that concern from the industry has prompted a 5% cap on production growth in 2011.

US Natural Gas production has surged since 2005 as a result of new deposit discoveries and producers responding to the pitching of natural gas as the "fuel of the future."

At the same time, consumption of natural gas in the US has not kept pace with the supply increases. Gas usage has remained more or less unchanged over the last decade. This could gradually begin to change as new housing starts begin to recover. Most new houses and industrial buildings use either Natural Gas or Electric for heating. With power plants shifting towards cleaner gas and away from coal to fuel their electricity production, natural gas very well could become the fuel of the future. The problem for prices is, it hasn't yet become the fuel of the present. In fact, the EIA expects total natural gas consumption to decline by 0.9% in 2011.

While production has continued to rise, US Natural Gas consumption has remained relatively stable throughout the decade.

This supply/demand imbalance has been reflected in inventories for the last couple of years, a major factor in keeping a lid on Natural Gas prices for most of that time. Working inventories at year end 2010 stood at 3.1 trillion cubic feet (Tcf), near record highs for the that time of year. The EIA expects inventories to remain near record levels throughout 2011.

The production/consumption imbalance has resulting in natural gas being plagued by a continuing overhang in inventories. Although headed into peak usage period in the US, Natural Gas storage levels remain near record highs for this time of year.

Strategy

Natural gas is one market that can be heavily influenced by seasonal factors. While we expect large inventories to keep average prices relatively low in 2011, prices will fluctuate within a defined range which could have a topside at or above the $5.00 level basis the June contract. As usage increases during the winter months, inventories tend to fall. Prices are more susceptible to upside movement when inventories are at their lowest - generally at the end of winter (see above chart). The EIA expects storage levels to be at 1,774 billion cubic feet (bcf) at the end of the winter heating season (March 31). If realized, this would be an all time record for this time of year. And then, as demand wanes, inventories start to build from there.

This does not paint a bullish picture for natural gas prices. We feel selling calls at strikes 75-100% above the market price for natural gas will be high percentage premium builders this winter and spring. While a seasonal rally in March or April might be the opportunity for patient investors, we believe any sporadic "cold weather" rallies would be opportunities for selling deeper strikes before then. This market will, in our opinion, have a hard time sustaining any bullish price surges at all given the supply overhang in natural gas. Any one that comes along should be considered a call writing opportunity.

Price Chart Courtesy of CQG, Inc.

Fundamental Charts courtesy of Hightower Research

The information in this article has been carefully compiled from sources believed to be reliable, but it's accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.