Front-month May natural gas futures are trading up over 20% from the February low of $3.26 per MMBtu, flirting with the top of the $3-$4 range in which prices have languished for the past year (Chart 1). The sharp rally was fueled by colder-than-normal temperatures across the US, where roughly half of homes rely on the gas for heating. When measured in Heating Degree Days (a commonly referenced measure of heating demand), the first two weeks of March have been about 3.3% colder than the average of the past five years.
This increased heating demand has been reflected in higher-than-normal withdrawals from storage, with more gas coming out of storage in each of the past four weeks relative to the same period during the past five years. Though, when viewed in the context of total gas in storage (i.e., in percentage terms), the withdrawals have been completely in line with historical norms. Market bulls have made hay about the large decline of gas in storage year-over-year, though this is misleading, because last year was an aberration (Chart 2). When measured against the five years before 2012, there is 14.1% more gas in storage for this time of year. The fact is, weather can have a short-term impact on natural gas prices, but the long-term fundamentals remain in place.
Since the expansion of shale gas exploration began in earnest in 2005, US domestic production of natural gas has been on a steady march higher (Chart 3), with demand unable to keep pace with the growing supply. This has effectively capped the upside for natural gas prices in the US, trapping spot prices in a tight range. Long-term prospects for higher prices are developing; however, the realization of higher natural gas prices is still a distant event, one that will be discussed in detail in a later note.
Adding further wind to the sails for short sellers is the persistently positive roll yield in the natural gas forward curve. Over the past 12 months, shorts have earned a cumulative return of about $1.08 rolling their positions each month, a substantial profit equal to roughly 25% of the underlying price of gas at current levels. While the forward curve has flattened in recent months, the positive carry persists, and natural gas front-month spreads have demonstrated a consistent tendency to widen as they approach the roll date.
We have been long-term bears on natural gas, and given the overbought condition of the market coupled with recent weather reports calling for above-normal temperatures beginning in April, now is a good opportunity to establish a new short position. Sell May natural gas, placing initial stops at $4.40.