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2012 Natural Gas Price Forecast: Why to Avoid the 'Widow Maker'

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"Natural gas has collapsed in price instead of climbing during the peak winter cold months, but this price drop has more to do with U.S. production rising on a year-over-year basis than it does the weather."

I've been watching natural gas (NG) for years now and find myself shaking my head lately.

The cost to buy the "clean energy" is collapsing as crude oil, a product that needs refining, stays above $100/barrel (bbl).

In fact, this chart for natural gas is what I call a Widow Maker.

Take a look:

natgas1

As you can see, it shows the price of the March 2012 NG contract over the past two years—and it's not pretty.

Why Natural Gas Prices Will Continue to Drop

The last time I wrote about natural gas for Buy, Sell or Hold was November 2010.

At the time, natural gas was about to start its most seasonally bullish period of the year. I recommended a multimonth trade with an exit by the end of the March 2011 contract.

However, this year is completely different. Natural gas has collapsed in price instead of climbing during the peak winter cold months.

While it's been a warmer than normal winter across the United States, especially in the Snow Belt, this price drop has more to do with U.S. production rising on a year-over-year basis than it does the weather.

Ordinarily, the ratio of gas to oil on a BTU basis is 6:1. Today, with natural gas selling for $2.65/1,000 cubic feet (Mcf) or so and crude over $100/bbl, though, the same ratio is currently 37:1—not even close to the historical benchmark.

The next chart explains why natural gas pricing is going down and will stay down longer than most people expect.

natgas2

Currently, the number of natural gas rigs is still climbing in the Eagle Ford area, while remaining level in the Bakken and Marcellus shale formations.

Why this matters is simple: These rig counts will have an impact on U.S. natural gas prices far into the future.

Here's why.

Eagle Ford shale wells, while called "gas," have a "wet sweet" production profile. In other words, they also produce natural gas liquids.

These liquids are super sweet (that is, they are very low in sulfur) and make a great blending stock with heavy sour oil, allowing producers to take two products derived at subspot crude oil prices and blend them into a West Texas Intermediate (WTI) equivalent.

Again, these wells are being drilled for their crude oil-like liquids rather than their gas, at close to $100/bbl for crude versus about $2.65 Mcf for natural gas.

The kicker? They typically have to produce the gas anyway to lift the liquids out.

As a result, the natural gas market stays saturated with new incremental supplies, which works to keep natural gas prices low.

I expect this trend to continue into 2012, making higher natural gas prices unlikely.

Oversupply: A Glut of Natural Gas

A bit of history shows us why. . .

Before the build-out of natural gas combined-cycle power plants in the 1990s, the United States had a yearly glut in gas. Producers actually shut down their production wells for months at a time.

What's more, there was no takeoff capacity to produce more gas, since the pipelines were full and the storage facilities were maxed out.

Today, we have returned to a similar environment.

In fact, the United States has a large selection of individual natural gas basins and prices are rarely the same in each, due to pipeline takeoff capacity and other similar factors.

As a result, we could see individual basins with a short-term price of $0.00/Mcf this summer. That's no typo. The cost of natural gas in certain places could go to zero.

Further, I expect to see unhedged natural gas producers go bankrupt this fall, since the cost to carry production on leased lands exceeds the value of the cash flows from the fields.

You see, natural gas will be worthless to its producers for a period of days or weeks at a time.

This will impact the top and bottom lines of companies that have to produce, let alone sell, into that environment.

There may even be localized negative rates created when a company has to produce from lease properties or return the ownership to the mineral rights holders.

It is a case where companies put millions into drilling wells on a ranch and then can't sell their product because there is no market for it.

The Long-Term Outlook for Natural Gas

I don't expect to see a clear trend change in natural gas prices until 2013 or later, depending upon the build-out of U.S. liquid natural gas (LNG) export capacity.

The U.S. government has received a growing list of requests from LNG import facilities, to allow them to be converted into LNG export facilities. These conversion projects will start to come online in 2015. So far there have been plans submitted to export the equivalent of 17% of the United States' daily natural gas production, but for now that production has to sell within the United States—or not.

If all of these facilities are built, the United States could be the world's largest liquid natural gas exporter by 2020. Just a few years ago the United States was projected to be the largest consumer of liquid natural gas by 2020.

Needless to say, the swing from one extreme to the other has been staggering.

In the meantime, smart investors will stay out of the way of the Widow Maker. Expect natural gas prices to stay low for 2012 and beyond.

It is also time to start considering the impacts that a natural gas glut will have on the companies providing drilling supplies to the exploration and production (E&P) companies.

Some high-flying stocks in the oil and gas service sector will be negatively impacted when the rush to drill and frack a shale well is over. The golden days of the shale rush are just about over and with that, a return to gravity for some of these high-flying stocks.

In my next Buy, Sell or Hold piece, I will be looking at one of those high-flying stocks, which is facing a moratorium on its business model.

The implications are bigger than the market realizes.

Jack Barnes, Money Morning


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