Reasons To Be Bullish

• Print
• E-Mail

Regular readers of The Energy Letter and The Energy Strategist know that I've been negative on the US economy for some time. As I explained in my free e-zine Pay Me Weekly, my favorite gauge of US economic health is the Index of Leading Economic Indicators (LEI), released monthly by the Conference Board.

To make a long story short, LEI first signaled a recession in the US in late 2007--the indicator proved prescient as the recession began in December of that year. Unfortunately, as I explain in the Mar.20, 2009 issue of PMW, I don't yet see conclusive signs of a turn for the economy.

Weak economic growth has been the primary fundamental driver of downside in the global oil and natural gas markets since last summer. As consumers cut back on spending amid the weak economy, demand for gasoline, jet fuel and other refined products slumped and global stocks of crude oil rose. A relatively tight global supply situation in the first half of the year quickly turned into a glut.

I had expected natural gas to hold up better; electricity demand and demand for winter heating are less sensitive to economic conditions than demand for gasoline. I've always prided myself on being willing to admit when I'm, wrong; I just didn't foresee such a large dropin industrial demand for gas. The best indicator of industrial gas demand is industrial production.

Source: Bloomberg

This chart shows the year-over-year change in US industrial production going back to the early 1970s. On this basis the US recession has surpassed the recession of the early '80s and has reached levels unseen since at least 1974. That '74 recession is the worst downturn since the Great Depression.

Industrial demand makes up around a third of US gas demand. Despite a big jump in heating demand caused by the cold US winter, a slump in liquefied natural gas (LNG) imports due to high gas prices overseas, and still-strong US electricity demand, gas demand has slumped. Inventories are hardly at extremely glutted levels, but right now they're some 200 billion cubic feet above expectations.

But despite the steady drumbeat of bad news on the economy and oil and natural gas demand, I'm turning more bullish on energy commodities and related stocks. In fact, I'm more bullish on the sector now than I've been since last summer.

Here's a rundown of my reasons for becoming more bullish.

The US gas-directed rig count is plummeting at a record pace. The gas-directed rig count is simply a measure of how many rigs are actively drilling for natural gas in the US. Since last summer the rig count has plummeted by close to 50 percent from highs of over 1,600 to around 850 as of the end of last week. This is the fastest rate of decline in this measure in history.

Historically, declines of this nature have been extremely bullish for natural gas prices.

Source: Bloomberg

This chart shows two pieces of data overlaid for easy comparison. The white line is the Baker Hughes (NYSE: BHI) gas-directed rig count, a measure of how many rigs are actively drilling for natural gas in North America. This data is released weekly. The red line is the 12-month New York Mercantile Exchange (NYMEX) natural gas strip price. I've normalized both data to make comparison easier.

Note how these two lines tend to attract one another. When natural gas strip prices fall sharply, you tend to see a drop in the gas-directed rig count. This occurs because producers slow their drilling activity due to weak project economics. This is exactly the effect you'd expect.

But note what happens when the rig count drops precipitously. A severe drop in the US gas-directed rig count invariably catalyzes a massive rally in the strip. Note, in particular, the action back in the 2001-02 cycle: A few months after gas prices began falling, the rig count dropped sharply--by around 50 percent--over several months. But a few months before the rig count bottomed out natural gas found a low and proceeded to double in price in about a year.

Of course, the rig count could drop further. But the most recent Energy Information Administration survey for December indicates that we're already seeing US gas production beginning to fall. At the current pace the rig count would plummet to around 600 to 650 by mid-May. That would be consistent with annualized declines in gas production well in excess of 5 percent. Supply would be dropping at many times the pace of demand.

Gas could continue to be weak as winter heating season comes to an end. But the most expensive words in finance are "it's different this time," and I see no reason to believe the precipitous drop in the rig count won't filter through into higher gas prices.

Oil market contango is fading. Contango is a term that refers to the shape of the futures curve for a given commodity. The best way to illustrate is with an example; see the chart below.