Over the course of the next two columns, I plan to finish up the recent look at BP’s Statistical Review of World Energy 2014. The final two columns will focus on renewable energy, and carbon dioxide emissions.

Today I want to provide an update on the natural gas picture, as prices declined sharply at the end of July. I have laid out the argument since last winter that because of the deep inventory hole that developed over the course of the exceptionally cold winter, natural gas prices would remain high relative to last year, and that as a result natural gas producers would likely report higher year-over-year profits. (For background on the inventory picture, see my February column Natural Gas Inventories are Headed Toward Zero).

First, let’s look at what natural gas prices have done since winter. The chart below from the Energy Information Administration (EIA) shows that natural gas prices have been higher this year than they were either of the past two years as expected, but that toward the end of July the price fell sharply.

Seasonal Natural Gas Analysis

So what has happened? Two things. The first is that producers have been producing at higher rates than they were either of the past two springs. Thus, on the supply side the situation looks pretty good. In fact, the EIA recently reported that natural gas production in the Marcellus Shale region had exceeded 15 billion cubic feet per day (Bcf/d) for the first time ever.

But the bigger issue — as it was in the winter — has been unseasonable weather. Generally in the summer demand for natural gas spikes as utilities react to increased loads from air conditioners. This summer has been like this past winter — cooler than normal. In fact, this summer is flirting with record cool temperatures across many cities across the US, and that has reduced the demand for natural gas. This has meant that inventories are recovering faster than expected, and that has reduced the fear premium that existed in early spring. Gas inventories are still below normal for this time of year, but the potential for more cool weather has investors betting that inventories will be in good shape once high demand season begins:

ngs

Natural gas producers have been reporting higher year-over-year earnings as I expected, but many have sold off over the past month due to concerns about shrinking margins. Natural gas prices have recovered some of the year-over-year premium in recent days — the current price of $3.97 per million British thermal units (MMBtu) is $0.63/MMBtu higher than the price a year ago — but if the summer continues to be cool it is much less certain that premium will be maintained.

One word of caution though is not to be confused by natural gas seasonal pricing effects. When I argue that natural gas prices will be higher, I have always tried to make it clear that I am referring to year-over-year prices, which will impact year-over-year profits for gas producers. But July gas contracts will generally be cheaper than February contracts because of seasonal demand. So you can expect in most cases gas prices to actually decline between winter and summer, but the year-over-year differential is what is important.

Conclusions

My thesis last winter was that low inventories would lead to higher year-over-year natural gas pricing, and that has proven accurate through the end of July. Year-over-year profits for gas producers have been higher. But a cool summer has meant that inventories have headed toward normal levels faster than expected.

Weather is always a short term risk factor in the natural gas market. If this winter resembles last winter, we will again see high natural gas prices, especially if we don’t recover to normal inventory levels by the start of injection season in ~mid-November. (Inventories are still 20% below the 5-year average for this time of year). But as recently as 2012 we had an unseasonably warm winter, and natural gas prices collapsed in response.

If you are a long-term investor in natural gas companies or infrastructure providers, these seasonal fluctuations are not important. Over time, they will average themselves out, and there are a number of factors that argue that natural gas prices will move higher than may be implied by natural gas futures prices.

Link to Original Article: Why Natural Gas Prices Collapsed