Morgan Stanley: Natural Gas

Natural Gas

Fundamentally Oversupplied

We see 2011 natural gas prices averaging $4.00/mmBtu as the US balance is fundamentally oversupplied and is likely to remain so through 2011.

After falling to a trough of 612 in mid-2009, drilling activity has trended higher, despite weak natural gas prices. The increase in rig activity, particularly horizontal rigs, is bolstering production — the latest from the EIA shows production higher by 1.5 bcf/d YoY in July. Using a 12-month moving average of rig activity, we see gas production maintaining its upward path through at least 1Q11, and possibly for longer.

Higher production will translate into increased inventory injections and lower withdrawals. We expect YoY inventory comparisons to get progressively bearish as we enter the heart of the heating season.

Forward prices will be under pressure. We are modeling end-Mar’11 storage at 1.9 Tcf and expect the 2011-strip (currently trading at $4.57/mmBtu) to be pressured. The key drivers of our bearishness include today’s elevated inventory position, the recent increase in rig activity and the lagged impact on production from an eventual decline in the rig count.

Trade recommendation: With end-Mar’11 inventory likely to be abundant, we see downside to Mar-11 gas prices, prompting our opening of a short Mar-11 position, currently trading at $4.27/mmBtu. While utility buying early in the heating season may support near-dated contracts, we believe that underlying bearish fundamentals will ultimately pressure prices lower. Our stop loss on this position is set at $4.60/mmBtu and we will exit this position at $3.50/mmBtu. Risk to this position includes a colder-than-normal winter or a fall in production exceeding our expectations, which would leave inventories below the 1.9 Tcf that we are modeling.

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