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Will the Natural Gas Market Continue to Cool Down?

The natural gas market has cooled down in the past several weeks after the Henry Hub price reached near-term highs earlier this year. Looking forward, will the price of natural gas keep falling? And how might the recent developments in the natural gas market affect the performance of leading natural gas producers such as Chesapeake Energy (NYSE: CHK  ) ?

Natural gas market cooling
The colder-than-normal winter pushed up the price of natural gas to record levels in some parts of the U.S., such as New England. The price of natural gas rallied mostly because of the high demand for heating purposes in the residential and commercial sectors. The elevated demand for natural gas has also been reflected in high extraction rates from storage. 

Here's a look at the change in natural gas total storage and prices between November and March of the past several years. 

Source of Data: Energy Information Administration.

The storage extraction rate of this winter was the highest in the past several years, which could partly explain the dramatic 75% change in the price of natural gas. The current Henry Hub price is still high for the season and is well above its level from last year. Nonetheless, the staggering rise in the price of natural gas is likely to change direction in the coming weeks. Let's see why. 

The currently high price of natural gas is likely to steer utility companies away from natural gas and toward coal. The Energy Information Administration expects the demand for natural gas to inch down by 0.1 Bcf per day to an of average 71.3 Bcf per day in 2014. The decline in consumption is mostly in the power sector. Furthermore, on an annual scale, natural gas producers aren't likely to benefit from the overheated natural gas market we saw this winter. Thus, as the power sector continues to cut down on its natural gas consumption and as the weather warms up, the price of natural gas is likely to follow and drop precipitately. 

Over the first quarter, however, the tighter natural gas market is likely to improve Chesapeake Energy's profit margin and revenue. In 2013, the company's natural gas revenue accounted for roughly a third of its production revenue. Since the quarterly price of natural gas is around 37% higher year over year, this could pull up Chesapeake Energy's production revenue, assuming all else equal, by 12%. 

But because of an expected drop in the price of natural gas over the long run, the company has slowly reduced its natural gas operations. In 2014, the company estimates that its natural gas production will inch down by 1% year over year. Nonetheless, its natural gas operations are still likely to account for more than a third of its production revenue. 

The recent developments in the natural gas market have benefited those who invested in United States Natural Gas (NYSEMKT: UNG  ) , a natural gas ETF. In the past several weeks, United States Natural Gas has outperformed the spot price of natural gas because the futures market has shifted from contango to backwardation. Contango occurs when the prices of long-term future contracts are above the prices of short-term future contracts. When the market is in contango, the price of this ETF tends to fall below the price of natural gas. But when the market shifts to backwardation, in which long-term future contracts are below short-term future contracts, UNG tends to outperform natural gas. In the past several weeks, the futures market shifted to backwardation -- basically, the market expects the price of natural gas to drop in the coming months. Therefore, investors of UNG didn't suffer as much as natural gas investors did:

Source: Energy Information Administration and Google Finance.

UNG has outperformed the price of natural gas mainly in the past several weeks. If the future markets remain in backwardation, and if the price of natural gas continues to fall when UNG rolls over its future contracts, the price of UNG will remain above the price of natural gas. 

Natural gas is likely to fall further in the coming months. Moreover, the elevated prices of natural gas are likely to cut down the demand for natural gas in the power sector, which could also reduce the total demand for natural gas during 2014. Natural gas producers such as Chesapeake Energy will benefit from the recovery of natural gas in the first quarter of 2014, but down the line the expected decline in demand for this commodity could slash natural gas producers' revenues.  

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Lior Cohen

Lior has been a contributor for the Fool since 2012. His main interests are in commodities, and energy and materials companies.You can follow him on Twitter to stay up to date with his industry analysis. @tradingnrg

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9/1/2015 4:01 PM
CHK $7.57 Down -0.24 +0.00%
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UNG $12.71 Up +0.01 +0.00%
United States Natu… CAPS Rating: **