A Bottom For U.S. Natural Gas Producers Is In Sight

Crude oil is not the only energy commodity that has taken a beating over the last 12 months. U.S. spot natural gas prices, priced at the Henry Hub in Louisiana, closed Monday at $2.72 per million British Thermal Units. U.S. spot natural gas is down by $2.05/MMBtu, or 43%, over the last 12 months. UNG, the natural gas ETF, fared even worse, declining by 46% over the last 12 months.

As an aside, the under performance of UNG is due to the unique construct of the ETF. UNG seeks to replicate the performance of natural gas prices by purchasing the front-month natural gas futures contract priced at the Henry Hub, and rolling the contracts over each month. Since the natural gas futures curve is upward sloping (a technical condition labeled as 'contango'), this means investors in natural gas futures will lose money over time even if the spot price remains the same. As such, UNG is only good for short-term speculation.

Meanwhile, the stock prices of our 'watch list' of U.S. natural gas producers have also been beaten down over the last 12 months:

• Chesapeake Energy (CHK), $14.24, down by 40.4%
• Cabot Oil & Gas (COG), $27.53, down by 21.9%
• Range Resources (RRC), $46.61, down by 46.4%
• Southwestern Energy (SWN), $22.29, down by 47.6%
• Canadian Natural Resources (CNQ), $29.16, down by 20.5%

There are three major reasons for the decline in U.S. natural gas prices over the last 12 months, all of which have resulted in higher-than-expected supply:

1. Higher-than-expected production from the Marcellus shale, which makes up more than 20% of U.S. natural gas production. The Marcellus shale is unlike any other shale (gas or oil) in terms of productivity. Defying expectations, some of the wells drilled in the Marcellus shale actually experienced production increases six months after production began;
2. Technological innovation has driven efficiency gains as each rig is able to drill an increasing number of wells, e.g. three years ago, it took about 23 days to drill a well in the Marcellus shale; today, it takes only about 14 days;
3. An increase in 'associated gas' production as shale oil production increased, i.e. natural gas is produced as a by-product of shale oil production. The shale boom over the last several years has resulted in an increasing amount of natural gas produced that essentially has a zero cost of production.

We believe that much of the conditions for low natural gas prices is set to change in the near future, however, and that a bottom in both natural gas prices and stock prices of natural gas producers is in sight.

First, the number of natural gas drilling rigs has experienced a historic decline, and is set to drop further unless natural gas prices recover. The U.S. natural gas rig count peaked at 1,606 for the week ending September 12, 2008. Since then, it has declined by 83% to just 268 rigs as of last Friday, March 6, 2016.

Of course, increased drilling productivity means each rig could drill more wells today over any given time period relative to three or six years ago. However, we believe this unprecedented decline in the U.S. natural gas rig count will overwhelm any productivity gains--meaning that the overall number of natural gas wells drilled (and completed) this year will be lower than expected, unless prices recover.

Secondly, U.S. shale oil production will likely peak next month or in May given the current West Texas Intermediate crude oil price of around $50 a barrel. According to the just-released March 2015 'Drilling Productivity Report" from the U.S. Energy Information Administration (which covers U.S. shale oil & shale gas production until February, with projections to April), U.S. shale oil production growth will be stagnant by next month.

Three weeks ago, North Dakota's top oil official, Lynn Helms, observed that the state's daily production may have plateaued at around 1.2 million barrels a day unless prices recover. Since then, WTI crude oil prices have remained stagnant, while the oil rig count in North Dakota has continued to decline. With U.S. shale oil production set to peak next month or in May, the amount of 'associated gas' production will invariably drop as well--thus reducing overall U.S. natural gas supply.

Thirdly, natural gas demand, outside of demand fluctuations due to weather changes, will rise faster than expected as more energy-intensive manufacturing facilities are being brought back to the U.S. For example, Dow Chemical is building a $6 billion chemical manufacturing facility to take advantage of the rise in natural gas supply, while the North Dakota Senate just last month unanimously passed a bill providing tax incentives for companies to construct fertilizer or chemical processing plans (both of which are heavy natural gas consumers). The bill was specifically designed to encourage companies to build facilities to take advantage of the natural gas supply that is coming from the Bakken shale oil field. Already, there are three projects (totaling $9 billion) that have been planned to take advantage of this tax incentive.

With natural gas demand growth set to outpace supply growth, we expect U.S. natural gas prices to recover soon. Because of the unique structure of UNG, the natural gas ETF, we would not suggest purchasing UNG. We will instead look to purchase a select basket of U.S. natural gas producers, including CHK, COG, RRC, SWN, and CNQ to take advantage of this recovery.

Disclosure: Neither I nor my firm, CB Capital Partners, holds any shares in UNG, CHK, COG, RRC, SWN, or CNQ.