Higher Natural Gas Volatility to Come?

As I continue to work on my thesis, I have been spending an increasing amount of time thinking about the dynamics influencing the volatility of the natural gas market. With front-month contracts for natural gas down 29% since Dec-31 (see chart), historical volatility has also declined to multi-month lows, from a high of 131% (30D annualized HVOL) in Sep-09 to a current low of 30% (a 1.2 percentile event over the last year).

Accordingly, I think there is opportunity for notably higher NG volatility in the medium-term for the following fundamental reasons:

From a supply-side, conventional production (i.e., Barnett, etc.) is not going away anytime soon, and with a marginal cost for production higher relative to Shale gas ($5-8/Mcf vs. economical Shale gas at sub-$5/Mcf), it will help to establish a higher NG floor once demand comes back online. While shale gas is unarguably the future of our domestic natural gas supply story, supplying an expected ~29bcf/d, we are still likely going to be ~30+ Bcf/d short of demand in the longer-term, based on current U.S. NG consumption of ~60-80 Bcf/d (depending on season).

I think there is reason for more economical / lower marginal cost shale gas to not be in a place yet to replace conventional gas the way some sell-side analysts prosteletize (For instance, on May 27, 2009, one energy analyst noted, “Shale — along with other low-cost unconventional gas — could provide 75% to 90% of new gas supply over the next several years and set the marginal cost of new supply”). My line of thinking is as follows:

1. In the Marcellus shale, arguably one of the most economical shale plays (slightly ahead of the Haynesville shale), the pipeline infrastructure is not yet established in the region to provide adequate take-out capacity at a rate that is commensurate with current levels of production.
   
2. Current Appalachia production is ~2.5bcf/d, expected to grow to ~6 Bcf/d by 2013.
   
3. This is a lumpy process as new pipelines come online to match growing production.
4. However, pipeline capacity will get there in time: the major pipelines are still a few years away, with 6.9 Bcf/d of take-out capacity announced by Q413 (a bulk of which is back-ended).
5. Since the Appalachia area has heated up, companies have announced 6+ Bcf/d of new pipeline capacity - Key players in the Pipelines: EP, EQT, NFG, WMB, SE, D, NI).
   
6. In the meantime, I believe that this may contribute to higher volatility over time, particularly as greater drill-bit emphasis from operators is placed on unconventional / shale gas, while traditional (horizontal) wells dry out, reaching their EUR.
   

From a demand-side, I think there is a reasonable argument for NG demand coming back online late this year, perhaps sooner than may be anticipated, largely attributable to the substitution effects with Coal:

1. the pick-up in coal exports, which was 15.2 mm short tons in Q309, up from 13.0 mm short tons in Q209, implies that we are exporting ourselves into a tighter coal market. I believe the Q4 data released by the EIA later this month will give evidence to a continuation of that trend.
   
2. Increased economic competitiveness for power producers will compel a switch from Coal to NG.
3. Coal is still the lowest cost for energy production, but it is losing its economic competitiveness (see chart): For the U.S. as a whole, Coal energy production costs 19.8 $/MWh, down 11.6% YoY, whereas NG is 40.56 $/MWh, down 23.2% YoY, all as of Nov-09.
4. Coal prices are already up 9% from Q309, and I think this trend will continue if we get evidence of sustained larger coal exports to Canada and EM.

Bottom line:

• I agree that Shale gas is the new hope for the long-term, but in the near-term there are structural obstacles for it to fully replace traditional wells in the way that I think the sell-side is envisioning.
• Further, increased substitution from Coal into NG will help to bring demand back online later this year, likely in the energy consuming summer months.
• Once demand picks up, even slightly, I think we will see some violent volatility moves in the NG.
  
• Don't get me wrong, I am still bearish on the near-term outlook for NG prices - we are still materially over-supplied, but I think there are reasonable catalysts that can correct this dynamic in the medium term, which may not be given enough consideration.