Gas rally may be just wishful thinking

Is that light at the end of the long, grim pipeline to nowhere that investors in the natural gas sector have been sliding down?

Gas ripped higher again this week, raising hopes that the market for the fuel is breaking out of a funk that had taken the contract for gas delivered in a month to a seven-year low of $2.50 (U.S.) per million British thermal units (BTU) just four weeks ago.

Since then, the price for gas delivered in a month has almost doubled, finishing yesterday at $4.71 per million BTU.

Yet energy stocks had a rough week, dropping as a group and contributing to a 2.3-per-cent decline for the S&P/TSX composite index, in part because many investors have little faith in the gas rally.

So who's right? Has something changed to turn gas from a dead-end trade facing a terrifying supply-demand imbalance into a big winner, or are the skeptics who were unwilling to bid up gas stocks too far right to back off? Gas bulls are not going to like the answer given by Olivier Jakob, a well-regarded energy market strategist who runs Petromatrix GmbH from Zug, Switzerland.

“The fundamentals, I don't think, have changed in the past month,” he said, pointing to more numbers showing that North American economic growth and industrial production are not rebounding as quickly as hoped, and to the huge pool of gas that's sitting in underground caverns.

“We are way above previous years in storage levels in the U.S. and the trend is not changing.”

In fact, with 15 per cent more gas in storage than last year at this time, the caverns in the southern U.S. where surplus gas is kept are full.

With at least a full month to go (here's hoping) before really cold weather begins in the most populous regions of northern North America, there's not much hope of draining off any of the excess to run the continent's furnaces.

Economic growth doesn't look ready to ride to the rescue in the next month, either. After all, while figures this week showed the U.S. economy shrank at only a 0.7-per-cent annualized rate in the second quarter, not the 1 per cent most were expecting, there's no getting around the issue that the economy shrank – for the fourth straight period.

“You need, really, demand to come back. Until you start really to go back into better dynamics in industrial production, it's going to be a tough challenge.”

That's the short term. The long term isn't necessarily pretty, either.

A signal moment for many big natural gas investors was the announcement that liquid natural gas terminals that were designed during the good years to bring the fuel into a booming, energy-starved North America were being turned around to export gas instead. That heralds a future where the continent is in surplus for the long term.

Optimists point to hopes that gas will be shut in some time soon, with wells simply shut off. But that's a temporary fix. As soon as any rebound happens, those wells can easily be turned back on by cash-starved producers, limiting any gains in the price, Mr. Jakob argues.

“Gas is basically in the same situation that OPEC is in on the crude oil market,” he says. “They need to shut down production. But that is not bullish long term because you do then create that additional long-term capacity.”

However, the gas business lacks the cartel mentality that OPEC has, so there's little discipline to keep production down.

After dropping output in April, Chesapeake Energy Corp., one of the biggest producers in the United States, just brought it back to the company's regular rate. The company's chief executive officer told investors he wasn't willing to sacrifice his bottom line for the good of the industry, saying, “We didn't see any reason to take it on the chin for the team.”

So given those grim fundamentals, what caused the September surge in gas and is it sustainable? Probably not, if Mr. Jakob is right.

The gas market is in what's called contango – which means a steady rise in prices, with gas for delivery soon cheaper than futures for gas that will be delivered a few months from now. As a result, when the market “rolled” so that the contract that most people trade moved from October delivery to November delivery, which was trading at a higher price, the market jumped.

That's not going to last, Mr. Jakob predicts.

“We will have contango convergence, when we retrace to erase this jump that we had from the October to the November contract,” he said.

The other big driver was the buying caused by a quirk in the exchange-traded fund market. The biggest gas ETF, the U.S. Natural Gas Fund (UNG-N11.390.373.34%), had stopped issuing units for a few weeks because regulators were concerned that the fund was getting too big and controlling too much of the market.

However, demand for the fund's units remained strong. As a result, units rose well above the value of the gas contracts the fund owned – peaking at around a gap of 20 per cent. When the fund recently announced it would resume selling units, savvy traders bet that the gap would close. That easy money is now gone.

“The trade was to sell the [fund] and buy natural gas because this 20-per-cent premium would automatically come off when they start to issue new shares,” Mr. Jakob said. “That's what we saw.”