Lowly NatGas: Only For Bold Investors

As poorly as oil prices have fared this year, it's nothing compared to another energy commodity. Prices for natural gas―a fuel that is used primary for heating and cooling needs―are down 25% so far in 2016, far outpacing the 10% decline in crude.

By the same token, the United States Natural Gas Fund (UNG | B-94) is down 28% compared with 19% for the United States Oil Fund (USO | B-100).

The downturn in natural gas has only added to the woes of an energy industry reeling from the worst oil bust in decades. Unfortunately, just as is the case for oil, it is unlikely there will be any quick turnaround for prices.

Too Much Supply

At the heart of the problem for natural gas is supply. Output continues to hit record highs, confounding most analysts who have been calling for a decline. It wasn't supposed to be profitable to drill for natural gas at such low prices, said the analysts. But clearly, they underestimated the economics of the business.

Technological advances, which have reduced the breakeven price of drilling for natural gas in shale, are largely responsible for the supply glut and price decline. But there's also an element of unbridled enthusiasm on the part of natural gas producers, who, up until a year and a half ago, were rewarded by the stock market for increasing production at any cost.

Shut out of the debt markets and with their share prices in tatters, producers are finally starting to cut back, but it's not showing up in the numbers yet.

Just this month, output hit a record of nearly 83 billion cubic feet per day, according to PointLogic Energy.

US Lower-48 NatGas Production

To make matters worse, this winter has been one of the mildest on record, which significantly reduced demand. Inventories―which typically bottom out in March―are bloated, with 615 billion cubic feet more natural gas in storage than last year.

Production Outlook Uncertain

To be sure, current natural gas prices reflect the abysmal fundamentals of the market. Earlier this week, natural gas hit $1.68/mmbtu, the lowest level in 16 years on a nominal basis, and the lowest level on record when adjusted for inflation.

Natural Gas Price Chart

The question now is whether these prices will finally spur the supply and demand adjustments that many are hoping for.

It certainly looks like the drilling binge is finally coming to an end—but is it really?

On the one end of the spectrum, you have companies such as Southwestern Energy, whose shaky balance sheet have forced it to cut capital expenditures drastically. In fact, Southwestern says it's not currently drilling any new wells at all, but rather "managing [its] existing drilled but uncompleted well inventory."

Southwestern forecasts its output will drop 15% year-over-year under this strategy.

On the other end of the spectrum, there is Range Resources and Cabot Oil & Gas. With their relatively healthy balance sheets and higher-quality reserves, they are both forecasting growth in their production this year, despite lower capital expenditures.

Range sees growth of 8-10% for 2016, while Cabot sees growth of 2-7%.

Given these mixed signals and a history of upside surprises, it would be foolhardy to forecast with any conviction a decline in overall natural gas production for the U.S. At this point, inventors will need to see it to believe it.

Demand Slowly Rising

The outlook for U.S. natural gas production will be the key determinant of whether prices will remain depressed or whether they can stage a comeback down the line. But other factors such as demand and exports will play a significant role as well, longer term.

Natural gas will continue to gain share at the expense of coal when it comes to electricity generation, but not at the torrid pace of last year.

Power-sector demand was up nearly 20% in the first 11 months of 2015. However, much of that gain can be attributed to opportunistic coal-to-gas switching by utilities that can quickly move between the two fuels based on short-term economics.

Meanwhile, demand from industrial users declined slightly last year despite lower prices, a reflection of the struggling manufacturing sector in the U.S.

First LNG Exports

If demand alone is not enough to move the needle for natural gas and boost prices, perhaps exports will do the trick. Earlier this week, Cheniere Energy loaded its first cargo of liquefied natural gas at its Sabine Pass terminal in Louisiana, the first LNG export facility in the country.

This marks the start of a new era in which the U.S. becomes a major exporter of natural gas to the rest of the world, which will go a ways toward moving some of the country's abundant supplies elsewhere. This will effectively tighten the domestic market, potentially giving a lift to prices at some point.

In the near term, Cheniere only has the capacity to ship 0.65 bcf/d, but analysts expect LNG exports to grow to upward of 8 bcf/d by the end of the decade―equal to about 10% of current U.S. output.

Risky Sector To Invest

Even in the face of 16-year lows, it's hard to get excited about buying natural gas. The near-term fundamentals are horrible, and supply has remained stubbornly high despite promises of declines from analysts and producers.

On the positive side, demand and exports are moving in the right direction. If they succeed in absorbing the glut of supply that currently exists, perhaps prices can rebound to higher levels.

A diversified basket of exploration and production stocks, such as the First Trust ISE-Revere Natural Gas ETF (FCG | B-95) is a high-risk/high-reward way to get exposure to the space without having to deal with issues of contango that affect the United States Natural Gas Fund (UNG).

However, this ETF is not for the faint of heart. It's already down 23% this year on top of its 49% loss in 2015. Only the boldest of investors should wade into the natural gas pool.

FCG Price Chart

Contact Sumit Roy at [email protected].