Last week around half of the losses were recovered from the previous two weeks in what I would categorize as a modest short covering rally. A combination of an announcement of a cutback in dry gas production by Chesapeake plus a perception that the weather pattern could be changing (although now it does not appear to be changing until well into Feb at the earliest) was enough to send many of the weak shorts or first level exits out of the market and to the sidelines until another selling opportunity presents itself. It seemed to me that by the end of the week the short covering rally was starting to lose steam and as such the market may be resetting for a sell the rally mode in the short term.

Absent any other producers announcing a production cut back Nat Gas prices are still primarily driven by the weather and the impact the weather has on the inventory withdrawal pattern. The latest NOAA weather forecast is still very bearish for the six to ten day period as above normal temperatures are still forecast across just about all of the US through February 7th. The eight to fourteen day forecast is also still bearish but it is showing the east coast returning to more normal temperatures for the period February 5th to the 11th. I do not think the changing 8 to 14 day forecast is going to make a big difference in the performance of inventory withdrawals and as such I expect the surplus in total inventory will continue to build through the middle of February and possibly beyond.

The inventory overhang is over 20% above both last year and the five year average for this time of the year with about two months left to the main winter heating season. As we move into the February & March the cold temperatures (if they do show up) are certainly not going to be as cold as normal temperatures are in the month of January and may not be enough for inventory withdrawals to outperform history and catch up for all of the lost consumption so far this winter. Obviously I still remain bearish medium to longer term.

In this week's EIA weekly report they showed a nice depiction of the how wet gas production has been bolstered by the price of oil on the content of NGL's and ethane. Recall this past week Chesapeake only announced a shutdown of dry gas. With wet gas production is still receiving a very positive uplift form the liquids portion of the barrel it is unlikely to see any wet gas production shut-in anytime soon.

The profitability of natural gas liquids (NGLs, which include fuels such as ethane, normal butane, isobutane, and propane) has, in recent years, led operators to focus drilling efforts on so-called wet production areas where NGLs are relatively abundant. These areas include portions of shale formations such as the Eagle Ford in Texas, the Marcellus in Pennsylvania, and the Utica in Ohio, which underlies the Marcellus. Although both oil and gas prices dropped considerably from their 2008 highs, oil prices have since somewhat rebounded, while natural gas prices have remained relatively low, with NYMEX futures prices hitting 10-year lows and remaining below $3 per million British thermal units (MMBtu). NGL prices, which more closely mirror the price of crude oil, have been rising over the past couple of years. The figure below shows the indicated NGL price minus the natural gas price at the Henry Hub. (When below zero, this means that the natural gas price was above the indicated liquids price, such as in 2005, when Hurricanes Katrina and Rita led to Henry Hub price spikes.) The price of ethane, the most abundant and widely produced NGL, behaves somewhat differently from other NGL price series, and is tied more closely to natural gas prices.

The latest Baker Hughes rig count released on Friday showed another small decrease in rotary rigs deployed to the Nat Gas sector by 3 bringing the total to 777 and below the so called threshold when production normally begins to decline (based on history which may not be applicable today due to more hedging, etc). Rigs deployed to the oil sector stayed the same this week at 1225. Horizontal rigs increased by 1 and remain at near record high levels. The following chart kind of says it all when you plot Nat Gas rigs versus oil rigs and place the spot WTI/Nat Gas futures market price ratio on the chart. As long as the price trend continues E&P players are going to continue to be biased to oil drilling. IN fact the oil to Nat Gas price ration has widened to 37 or an all time record high level. At this level rigs are likely to continued to be moved out of the Nat Gas sector and placed in the oil sector. The most interesting take away from this chart continues to be the fact that although we have seen a significant decline in rigs deployed to the Nat Gas sector production has actually risen during the same period. A lot of the oil drilling also winds up finding associated Nat Gas and along with the latest drilling and producing efficiencies even with less rigs production is still growing. Finally with oil/LPG prices still rising a major portion (if not all ) of the outright Nat Gas producing losses at sub $3/mmbtu gas is being offset and thus reducing the urgency for many producers to cut production even if they are not completely hedged. The decline in Nat Gas rigs still seems like it has room to decline... as recently as the fourth quarter of 2009 less than 700 rigs were deployed to the Nat Gas sector. If the producing economics of Nat Gas continue to decline or even stay at current levels as we approach 2013 we could see an acceleration in the decline of Nat Gas drilling as it appears that many producers are not sufficiently hedged for 2013 and beyond. On the other hand if oil prices continue at current price levels more and more rigs are going to be deployed to this sector.

This week the EIA will release the weekly Nat Gas inventory report on its regularly scheduled day and time...Thursday, February 2nd. This week I am projecting a net withdrawal of 155 BCF which is modestly below both last year and the five year average for the same week. My projection for this week is based on a week that experienced more winter like weather over a major portion of the country as shown in the following table. My withdrawal forecast is based on the fact that heating related demand was below normal last week in most parts of the country. My projection will be below last year's net withdrawal level of 187 BCF and below the normal five year average net withdrawal for the same week of 186 BCF. Bottom line the inventory surplus will build again in this report period but not as strongly as over the last four or five reports. If the actual EIA data is in line with my projections the year over year surplus will widen to around 563 BCF. The surplus versus the five year average for the same week will widen to around 578 BCF. This will be a bearish weekly fundamental snapshot if the actual data is in line with my projection. I will update the industry projections in Tuesday's newsletter.

On the macro front the media is reporting that the deal between the Greek bondholders and Greece is all but done and should be announced as a final deal sometime during the upcoming week. The deal results in about a 60% haircut to the bondholders and opens the door for another tranche of bailout funds from the EU. IF noting falls apart over the next several days it will pave the way for Europe to move a bit more into the background and open the window for risk asset markets to trade more based on the fundamentals of the individual markets and not simply whether the EU will implode or not. that said it does not mean all of the debt issues in Europe are over and the problems have now been solved...not the case. It only means that one major issues will be in the background while the EU works out the changing of the EU treaty and any other short term issues ...like Portugal or Spain and Italy that may surface.

The equity markets ended mixed as the US dollar weakened throughout the week while the euro continued to strengthen. As the situation in Europe unfolded and by the time the end of the week arrived most all risk asset markets were still able to end the week in positive territory. Last week was yet another week about the positive coming from Europe and less about the positives coming from the US while the war of words between the west and Iran also continued. The action and volatility last week was in all of the oil and commodity markets as well as the global equity markets. Last week was all about market players trading around the cloud of uncertainty that seemed to marginally shrink for some (equities) risk asset markets. Equity bourses were higher even as uncertainty started to decrease by the end of the week. Precious metals increased strongly as the US dollar declined on the week and as cash moved into a variety of risk asset markets and into the euro.

I am still keeping my view and bias at neutral as the short covering rally could regenerate itself next week. That said the surplus is still building in inventory versus both last year and the five year average is going to get harder and harder to work off even it gets cold over a major portion of the US and as such for the medium to longer term I am still very skeptical as to whether NG will be able to muster a sustained upside rally over and above a short covering rally. As an intermediate play I have entered a short Mar/ long Apr Nat Gas spread position in anticipation of the inventory surplus continuing to widen. The WTI market remains above support but is stuck in a tight trading range at the moment. the momentum has also changed and starting to look toppy once again. However, I am still keeping my view at neutral. I am currently expecting intermediate support around the $97.60/bbl area basis WTI and $109.50/bbl level for Brent with resistance around the $104/bbl level for WTI and $113.75/bbl for Brent.

Currently markets are projected to experience another volatile trading week as the market anticipates a possible change in the weather pattern in a few weeks and more producers could possibly cut production.

Best regards, Dominick A. Chirichella dchirichella@mailaec.com Follow my intraday comments on Twitter @dacenergy