Wednesday, January 20, 2010

Natural Gas and Oil: A Closer Look at What Risks the “Short Sellers” Face

January 20, 2010

Financial short sellers love to speculate and trade the financial energy commodities, primarily natural gas and oil due to the liquidity and ease of clearing and leverage they can use to establish their positions. That is the advantage of having a functioning and healthy financial system.

However, when that system breaks down, the results are severe and swift and immediately impact each and every financial institution that is providing leverage to the hedge funds or in this case “shorts”; the clearinghouses seize financial assets and go into the market for immediate liquidation, which ripples through the market instantaneously in what the market refers to as systemic risk. In layman’s terms it’s a good old fashioned run on the bank and it’s not pretty and always leaves casualties.

Yet the age old problem shorts encounter when everyone piles into the same trade as they are today is they start sitting on top of each other, amplifying the systemic risk and crowding the potential orderly exit door, much like airplanes circling a busy airport, racked, stacked, and packed, as air traffic controllers would say.

Eventually each plane must land or crash for lack of fuel as every airplane has limited fuel reserves to circle the airport for a certain period of time. Short sellers are gambling that they have enough reserve fuel to stay aloft and not crash land.

How does that relate to energy commodities and the massive traffic jam we have in the natural gas and oil markets today called the “shorts”, well let’s look at some basic issues facing these investors, who by are packed like sardines in a trade, which is not novel, not unique, and certainly not complex.

Speculation is a double edged sword, when it works, rewards are generous, when the blade turns, and the results are catastrophic, especially if everyone is sitting in the same sardine can, much like the mortgage backed securities trade which took down Lehman Brothers, Bear Stearns, Merrill, and almost the entire financial system. There was no exit door big enough to allow the heard to get out quickly, efficiently and with any meaningful capital, as the market quickly went against them, thus the run on the bank.

There are two (2) peak energy demand seasons in the U.S. Lest we forget, we constructed over 250,000 megawatts of natural gas fired generation in the U.S. ten years ago with efficient heat rates (energy conversion factors), and they will be used more often each year going forward, as we experience more extreme winters and summers. That was a debt fiasco in itself, which led to the bankruptcy of NRG, PG&E National Energy Group, Mirant, and almost bankrupted many other companies and funds.

Investors should also keep in mind, that during peak season and usage, the mainline pipeline systems in the U.S operate at or near maximum capacity, and "statistical natural gas in storage" is not always available, which is why we have massive price spikes at the "City Gates" or major consuming and producing areas. (Chicago, New York, etc.)

While the NYMEX Natural Gas Futures Contract is a useful price reference, what is more important is what is happening on the ground at the wellhead, compression station, storage facility, power plants and industrial consumers and the City gates.

Do not be fooled or lulled to sleep by looking at one static statistic that says we have massive excess natural gas in storage in perpetuity. The situation on the ground is quite the opposite, we have massive infrastructure problems in the U.S., lack of pipeline transmission and laterals to service power plants and industrial users, as evidenced by the major natural gas delivery curtailments in late December and early January, or to use the analogy, a jammed exit door.

Mr. Miller's always refers to the example of the wind farm in the desert to drive the point home. You can build the most efficient wind farm money can buy today, but if you don't have wind, and you don't have a transmission line and a massive renewable energy credit and federal tax credit, you have scrap value. Thus, natural gas in storage is not natural gas in the pipeline, nor at the demand center where it is consumed.

Additionally, Mr. Miller points out that traditional storage models have become dated and are grossly underestimating the true injections and withdrawals of natural gas in the U.S. leading to substantial standard deviations in analyst estimates and reported withdrawals.

The net result is that in Mr. Miller's opinion natural gas withdrawals have been understated and the weather volatility combined with the undervalued summer volatility will drive oil and natural gas prices up substantially higher in 2010.

We have lost much of our executive expertise related to natural gas and oil contracting, hedging, and risk management over the last ten to fifteen years in the U.S. Don't be misled by a natural gas or oil producer announcing that they have hedged part of their production output as being something negative.

As Mr. Miller has opined recently, it is a very positive thing that we have producers and some semblance of a financial system that can actually still underwrite a long term contract or financial hedge, as that is a skill set and art that has been lost on the industry for quite some time, as well as a limited number of financial institutions that have the credit and capability to participate in that energy arena.

Don't go to sleep looking at the NYMEX futures contract and believe you have a grip on where natural gas prices or the market is going. The real market is on the ground, in the physical market, where producers and physical participant’s hedge and trade via the over the counter natural gas swap market, physical delivery points and use the natural gas forward price curve beyond eighteen (18) months.

Natural Gas is back in the mainstream, it is here to stay, and it is not going away just because a weather forecaster says that next week, next month, or next year are going to be a degree cooler or hotter.

Core commodities have staying power, and Natural Gas has been revived and a very big way. A true energy investor rarely has to look at NYMEX to know what is happening in the market, whether long or short. They know the physical market and infrastructure and watch closely to see when the sardine can is packed full.

It will be interesting to see how long the “shorts” can stay aloft in this environment and how much leverage their keepers, the financial institutions and clearinghouses are willing to provide them.

| about stocks: CHK, DVN, EOG, APC, APA, XTO, XOM, MRO, CVX, OXY, BP

Disclosure: Long Energy Companies

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