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Schork Oil Outlook: Hedging August NatGas Production

Tuesday, 31 Aug 2010 | 11:07 AM ET

Natural gas production in the Lower 48 U.S. declined for the first time this year in June. According to the EIA’s 914-Survey month-on-month output fell by 1.2% or 0.81 Bcf/day. Production in Wyoming continued a 7-month slide and posted the largest decline of the largest producing states for the month; down 0.38 Bcf/d or 5½%. Natural gas production in the Federal Offshore Gulf of Mexico continued a 4-month string of monthly declines, down by 0.30 Bcf/d or 4.8% and in New Mexico production fell for the first time in five months, but June’s 4.2% decline pushed production to the lowest level, 3.62 Bcf/d, since 1992.

As one would expect, the pullback in production coincided with a weak cash market. From March through May, gas for next day delivery at the Henry Hub in Erath, La. averaged $4.158, or 2½ cents a dekatherm below the average on the Nymex.

At the same time, the futures position on the Nymex held by producers, processors and other commercial users averaged a net short position of 12,413 contracts over the three months, but shifted (peak to trough) from a net of 24,399 short contracts (March 12th) to 348 long contracts (April 23rd).

Thus, as those hedges were unwound, production surged. To wit, in between February and May production in the Lower 48 hit four consecutive records, rising by 3.6% to 65.1 Bcf/d. In June production dipped to 64.3 Bcf/d, thanks in part to shut-ins related to Hurricane Alex in addition to poor economics. As temperatures surged at the beginning of the summer, prices for gas surged, but so too did producers' willingness to sell into the rally.

For example, as illustrated in today’s issue of The Schork Report, over the last year there is a strong relationship between natural gas prices on the Nymex (x-axis) to hedging activity by commercial users (y-axis), i.e., as prices rise, producers sell, especially when prices top $5.50.

Thus, in June and July cash values at the Henry Hub averaged $4.716, an increase of 13% to the March-May average and the relationship to the Nymex shifted from a 2½ cent discount to a 2.7 cent premium. The average futures’ position held by commercial interests increased by 54% to 19,106 net short contracts through the first two months of the peak cooling season. However in August the average position fell back to 15,580 net short contracts, a decline of 18½%.

Thus, with hedges once again being unwound, the question is, will we see a commensurate increase in production for August? Consider that since peaking on June 15th the relationship to gas for delivery this winter and gas for next summer’s refill-season has morphed from a 35.4 cent backwardation (i.e. the nearer term winter contracts at a premium to the longer dated summer contracts) to a 14½ cent contango (discount) as of last Friday.

In other words, the futures markets are hinting that production in August was strong… just in time for the third and final phase of this summer’s refill-season.

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Stephen Schork is the Editor of The Schork Reportand has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.

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