A European Natural Gas Market

Natural gas, unlike crude oil, is not an international market. The US, for example, only imports 3% of its natural gas consumption while importing 43% of its oil. As a result, markets around the world have developed much differently. The North American natural gas market is a completely separate entity that prices natural gas according to supply and demand at different locations. Asia and especially Europe, on the other hand, price natural gas by linking it to the price of oil.

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Commodity Exposure vs. Speculation

A new report from Rice University's Baker Institute by Kenneth Madlock and Amy Jaffe argues the Commodities Futures Modernization Act of 2000 is one of the main reason for high oil prices. A 2007 GAO study concluded the CFMA made it easier for financial players to obviate speculative limits and made it more difficult for the CFTC to regulate oil futures markets. The CFMA allowed oil to be used for risk management products that artificially drove demand. The report states that before the CFMA 20% of oil trading was from "noncommercial participants" (speculators) while today 50% of trading is from these participants. The graphs speak for themselves:

As you can see, the price of oil corresponds with the amount of speculators in the market. When oil peaked at $145, the percentage of non-commercial traders in the market was at its highest.

It is astounding how much opposition there has been to the idea that commodity prices are heavily influenced by speculators. It seems common sense that money flooding into a market will inflate prices, especially if the new entrants are net long. Commodity markets are simply fundamentally different than capital markets because they are intended to serve a completely different purpose. Commodity markets are meant to match supply with demand while capital markets are meant to efficiently allocate capital. When NYMEX oil futures trading is 10 times more than daily consumption, a market is no longer matching supply with demand (very few contracts actually end up in delivery). Peak oil, as it is commonly perceived, is a myth. Prince Turk Al-Faisal underscored this recently in an article in Foreign Policy. If peak oil is a reality and oil is a desparately scarce resource, why does Saudi Arabia have 4.5million bpd excess capacity?

I attribute much of the interest in commodities to trends in popular investment theory. The rising popularity of "absolute returns" and the success of funds who invested in alternative assets (great example is the Yale endowment managed by David Swenson) led to the conviction that all portfolios should have at least a 10% exposure to commodities, since this asset class is historically not coorrelated to traditional assets, thereby reducing risk. This wisdom was spread by consultants and has now become a firm staple of retail investing.

One place where this has been evident recently has been natural gas. After the turmoil of last fall, when commodity prices dropped across the board, investors piled back into commodities. Since retail investors can't buy futures, they bought many shares of commodity ETFs, especially USO and UNG, expecting prices to re-inflate. All commodities, that is, except natural gas. Natural gas actually fell and continued falling. Merril Lynch recently forecast it to go as low as $2/mmbtu. So while institutional investors shunned natural gas, retail investors literally could not get enough of UNG. UNG went from a $447m fund to a $4.5bn fund in three months. The fact that the fund is trading at a 19% premium to NAV underscores the retail demand.

There is nothing wrong with investors seeking exposure to un-correlated assets or hedging their risks with commodities, but these markets were clearly not designed for this level of activity. One good change would be position limits. A market that can be as easily manipulated as commodity markets needs many small players to be efficient, and not distorting elements like the UNG and USO.

(Interestingly, every recession since 1973 can be associated with some sort of oil shock: 1973 and the Yom Kippur War, early 80s and 1979 Iran Hostage Crisis, early 90s and Persian Gulf War, 9/11 and the early 2000s recession, and finally the 2008 oil shock and the "Great Recession." Obviously correlation does not imply causation...but why take the chance and leave these markets to undue influence?)

Natural Gas Price Outlook

Natural gas prices dropped to a 7-year low today, as NYMEX Henry Hub futures (for September) fell 17 cents to $2.95, breaking the $3 barrier. Natural gas has taken a drastic turn in decoupling from the price of oil after the financial crisis. Historically, a barrel of crude oil has traded at a 6-10 multiple of the price of one mmbtu of natural gas. However, during the last half-year, the price of oil has re-inflated to $70 while natural gas has languished at $3/mmbtu due to negative fundamentals.

The drop in natural gas seems strange considering the number of rigs drilling for natgas have dropped by 58% since September 2008, according to Baker Hughes. With conventional production dropping, how come the US department of energy expects stockpiles to reach a record 3,800 mmbtus in November? The reason, according to BoA/ML Energy, is unconventional production from shale has become more profitable. Some producers report being able to find costs as low as $1.5/mmbtu, allowing them to lock in substantial margins with January 2010 futures trading at $5.47/mmbtu.


Considering these economics, natural gas is likely to fall further in the short term as inventories continue to swell. But this cannot go on forever. Due to the difficulties of storing natural gas, storage space is very limited. As inventories rise, the price of storage will rise, pressuring the natgas forward curve towards backwardation. Another risk is regulatory action from the CFTC. The CFTC is holding hearings on whether to limit some dealers' positions in natural gas. This could cause temporary selling pressure as funds decrease their positions.

While there are strong reasons for low natgas prices in the short term, there are good reasons to be bullish on natgas in the long term. One of the best reasons is cap-and-trade. Climate change legislation promises to raise the price of coal and oil relative to gas (gas has lower carbon emissions). In terms of electricity generation, the price per MWH for natural gas will converge closer to that of coal, increasing demand for natgas. In terms of transportation, increased use of liquefied natural gas (as the Pickens Plan promotes) instead of oil will obviously raise demand, as will the increased use of electric cars. I would not be surprised to see natgas trading at $6-7 /mmbtu in 2010, though the long-term future of natural gas ultimately depends on the sustainability of the economics of shale production.