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.
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.
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.
This chart shows the crude oil futures curve on three distinct dates, the beginning of 2008, Feb. 1, 2009, and Mar. 25, 2009. This chart is simply a graphical representation of crude oil prices based on the NYMEX futures contract.
For example, looking at the orange curve, representing the futures curve in early 2008, we can see that February 2008 oil futures were trading just under $100 a barrel, while May 2012 futures fetched about $90. The futures curve sloped downward, a condition known as backwardation.
The other two curves in the chart are upward-sloping, meaning that near-month crude oil futures are trading at a discount to futures expiring months and years in the future. This is a situation known as contango. Typically, contango indicates a near-term glut of crude--the glut puts pressure on near-term oil futures prices.
The key point to note is that although the crude oil futures curve today (pictured in white) is still showing contango, it's not even close to as steep a curve as it was back in early February. This indicates that concerns surrounding a near-term glut of crude are far less acute than they were in early February. I expect this reflects the growing expectation that falling global oil production will begin to reduce glutted US inventories of crude and refined products in coming months.
Liquefied natural gas (LNG) risk is vastly overblown. This is an extraordinarily common argument for natural gas bears; it also seems to be recycled regularly by journalists in various newspapers and magazines.
The idea is simple: A large number of new LNG liquefaction plants are due to come onstream in 2009, and many have contracted to send some of their output to US shores. For those unfamiliar with LNG, it's basically a technology that allows natural gas to be transported over long distances by tanker ship.
The idea is that this summer, as natural gas demand fades (no more winter heating demand), this gas will start hitting US shores and add to the glut of gas in storage. Moreover, the US has far more LNG import, storage and gas transportation capacity than any other major LNG importer. So the US is the market of last resort for LNG shippers--if there's no storage capacity for LNG in other countries it'll have to find its way to the US.
I see several problems with this argument. First, the actual amount of new liquefaction capacity coming online is likely to be less than the bears suspect. Several projects have been delayed, which isn't uncommon for major LNG projects. To the extent that capacity is coming onstream this year much of it won't likely begin sending out gas until after the summer months.
Second, contracts to ship gas to US shores are typically quite flexible. Just because a firm in the US signs a contract to buy a given quantity of LNG from a certain producer doesn't mean those cargoes can't be diverted to other markets where prices are better. In fact, such diversions are routine.
Third, gas prices in South America, Europe and Asia are higher than in the US. This makes the economics of diverting cargoes away from the US favorable.
Finally, EU gas storage levels are actually lower than a year ago thanks to a cold winter and the Ukrainian gas dispute. This is an obvious market for any excess LNG cargoes. And there's still considerable worry about the Ukraine given that nation's precarious fiscal condition and the ever-present risk of another dispute with Russia. Bottom line: More LNG will flow into the US this year than last, but it won't be the surge that some bears are projecting.
Signs of a revival in the Chinese economy. China and other developing countries have been key drivers of global oil and natural gas demand in recent years.
One might argue--convincingly--that the rapid jump in demand from these countries was the single largest driver of higher energy prices over the past five years. A slowdown in the growth of Chinese oil demand has been a major factor in the subsequent slump in crude oil prices.
But there are real signs of a revival in Chinese economic growth; the government's massive stimulus package is starting to work its way through the economy. I offer a detailed rundown of these signs in the Mar. 6, 2009 issue of Pay Me Weekly, Trouble at Home, Hope Abroad.
Signs of a moderation in the pace of US oil demand decline. One aspect of the weekly crude oil inventory reports released by the EIA that's often ignored is the data on US oil and gasoline demand. The EIA measures demand over a trailing four-week period and compares it to the same period of the prior year. As the chart below shows, at the very least the pace of US oil demand destruction has slowed.
Source: Energy Information Administration
This chart shows a composite of total US demand for refined products and oil. The pace of demand destruction has roughly halved from falling about 8 to 10 percent annualized last fall to closer to 4 percent so far this year.
And in the most recent report from the EIA, the agency reported that US gasoline demand is actually higher year over year by 0.7 percent; the biggest percentage decline in demand is for jet fuel, likely due to the fact that airlines are cutting capacity and eliminating unprofitable routes.
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