Investors hoping for a turnaround in natural gas prices may have to wait until the second half of the year, at the earliest.
Prices for the commodity, which is used for heating homes, power generation and to make plant food, have been in a downtrend for almost two years. Front-month futures contracts were recently trading at $2.188 per million British thermal units on the Chicago Mercantile Exchange. The last major peak in prices was in February 2014 at more than $8, according to the Energy Information Administration.
Reasons for the rout are legion and include the global decline in commodity demand, increases in supply from new techniques of extraction and a strong U.S. dollar, which makes all dollar dominated materials cheaper.
“One fundamental issue is that the resource space is highly productive,” says Lou Pugliaresi, president of the Energy Policy Research Foundation in the District of Columbia.
Fracking adds to the supply. The Marcellus shale formation in the Appalachian basin was a particularly fruitful find, especially after the development of horizontal drilling techniques and hydraulic fracturing, known as fracking. The find has spewed supply into the market.
Meanwhile, global temperatures in the last two years were the highest on record — reducing the demand for home heating.
But there are reasons to believe that the bull will be back in 2016, or at least the bear may be banished.
The switch from coal-powered electricity generation looks likely to help lift demand. “Natural gas seems well situated for another year of strong power burn in 2016 as low natural gas prices in [the first half], new gas-fired generation and continued coal plant retirements boost power burn,” says Barclays analyst Nicholas Potter in a recent report.
Coal-fired plants accounted for less than half of all U.S. power generation in 2014, a drop from nearly 60 percent in 2008, Potter says. It is a trend that is helping natural gas, as well as renewable energy sources such as solar and wind. The lower gas prices are only adding to the trend of making gas-fueled power more economic.
Potter sees that extra power demand helping lift prices to an average of $2.56 in 2016, up from a recent price of $2.12.
There’s no bottom yet. On the supply side, it is clear that production needs to decline — and the lenders of highly indebted companies will have a critical role in making that decision. The lenders clearly are already nervous about rising risks.
“Credit spreads have expanded, but the default rate hasn’t,” says Tim Rudderow, CEO of Mount Lucas Management in Newtown, Pennsylvania. Investors are demanding higher interest rates to lend to the indebted companies in the gas patch because of the increased risks involved, but the reality of rising defaults on the debt hasn’t materialized yet.
“When the default rate moves up, that will be a pretty good indication of a bottom,” Rudderow says.
Because gas prices are low, debt-laden drillers are continuing to pump gas from wells in order to service the loans. Eventually, there will be defaults — and then creditors will start taking over companies or renegotiating the terms of the debt, Rudderow says. In some cases, decisions will be made on whether to continue drilling. Eventually, that will mean a reduction in supply.
But that will take a while — low prices eventually reduce supply, and/or leads to increased demand. “Nothing cures low prices like low prices,” Rudderow says. “[It] takes longer to eliminate production.”
The wild card for demand is mother nature. “So much of natural gas demand is weather-dependent,” says Mark Hanson, a natural gas sector analyst at Morningstar, a market data and research firm in Chicago. “In winter it is used for space heating and in summer more electric power is needed for air conditioning.”
Ideally, for a big jump in demand the industry needs a cold winter and a hot summer. Some benefit may come to the U.S. courtesy of a weather pattern rarely discussed: La Nina, which follows its better-known sibling El Nino.
La Nina historically has meant dry and warm conditions in the Midwest, Hanson says, and when it last occurred in 2010, summer temperatures rose 13 percent from the previous year. A new La Nina will occur when El Nino ends, and could come as soon as the fall or early 2017.
So what should investors do? For the amateur, it is probably best to stay away from the futures market. That market is dominated by professional investors and losses can mount quickly because traders usually borrow money. If you feel the need to bet solely on the price changes of the commodity, then try the U.S. Natural Gas exchange-traded fund (ticker: UNG), which aims to track changes in the price of the U.S. natural gas spot market. UNG has $472 million under assets and has an expense ratio of 1.14 percent, or $114 per year for every $10,000 invested.
Alternatively, there are the equities.
Hanson recommends Cabot Oil & Gas Corp. (COG), which he values at $40 but recently traded at around $18.40; or Southwestern Energy Co. (SWN), which he values at $21 versus a recent price around $7.90.
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Is the End in Sight for the Natural Gas Slide? originally appeared on usnews.com
