December 19, 2018

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Natural Gas Soars On Possible Early-January Cooldown--But Is That Enough? Crude Oil Plummets To 16-Month Low On Russian Production Record Ahead Of Expected Bearish Inventory Build In Today's EIA Petroleum Status Report; Natural Gas Volatility Leaves Leveraged ETFs In Ruins; Gas Demand To Fall Today As Northeast Warms

6:00 AM EDT, Wednesday, December 19, 2018
Natural gas ended a 22% 5-day sell-off in style on Tuesday, soaring 8.8% for the biggest single-session gain since November 28th, and the fourth largest since January 1, 2017. The commodity closed at $3.84/MMBTU, one day after settling at $3.53/MMBTU, the lowest since November 12, and just one week after closing at $4.54/MMBTU. As the Figure to the right shows, natural gas 10-day average daily volatility has been at an extreme recently, averaging +/-3.68% per day, up 1.22% over last year's already-volatile +/-2.46% per day. Since bottoming out at a tepid +/-0.8% per day shortly after Labor Day, natural gas volatility increased nearly 10-fold, peaking at just over +/-6% per day on November 22, amidst historic upward and downward moves, including back-to-back daily net gains and losses of 12%. This was the highest average daily volatility since early 2014. The reason for the whiplash has, of course, been investor pre-occupation with computer models. With even a hint at a pattern shift in a run of the GFS or ECMWF--or their ensembles--prompting either sell-offs or short squeezes, trading natural gas this winter has been a huge challenge. This is particularly true for buyers of the 3X natural gas ETFs, UGAZ and DGAZ. While the 20%+ daily moves have been a godsend for day-traders and swing-traders, buy-and-holders of either product have been victimized by volatility-enhanced leverage-induced decay. While it is well-known that these leveraged ETFs underperform over the long-term due to their structure, the surge in volatility has sped up that process dramatically. Since November 1, natural gas futures prices are up +18.6%. During this time, the 1X ETF UNG is up a reasonable +12.1%. However, UGAZ is actually down -5.2% during the same period versus a +36.3% predicted performance (+12.1% X 3). Additionally, the 3X inverse ETF DGAZ is down -70.1% versus a predicted decline of -36.3%. Both of these products have disappointed investors in a big way, even if that investor actually predicted the correct 6-week move in natural gas. This is why one of my major mantras is "Don't Buy And Hold Leveraged ETFs--Especially During The Winter." Admittedly, I violated this axiom just last week, buying DGAZ on the pullback. However, this was a risk-reduction strategy, was only for a short period of time in a dramatically overvalued commodity in which a linear downward move was more likely than continued volatile chop, and any leverage-induced losses were partially offset by a concurrent short UGAZ position. With natural gas having sold off back into a more neutral territory, any natural gas trades on my part going forwards will be to short UGAZ or DGAZ, positions which benefit from leverage-induced decay. Click HERE for more on natural gas volatility data.

Monday's big move higher was due, unsurprisingly, to a cooldown in one of the computer models. As the Figure to the right shows, the GFS model has trended sharply colder over the last 24 hours, with 14-day forecast gas-weighted degree days climbing back above its trend line, even if the degree day outlook is still well below-average. The model is now suggesting a period of colder temperatures during the last few days of 2018 and first few of 2019 as a trough allows modified arctic air to move southward from Canada. This idea is confounded somewhat by the fact that the ECMWF-ENS model, while colder than the GFS at baseline, has not seen a similar cooling trend with forecast 14-day degree days holding roughly steady over the last 24 hours, as the Figure shows. On the other hand, the long-range ECMWF model--the 44-day ECMWF-EPS--that comes out twice weekly painted a much colder mid-January picture in its Monday run, a dramatic flip from last Thursday's run, also supporting Monday's rally. Click HERE for more on the latest long- and short-term models on my Advanced Models Page.

While I had been expecting a bounce after Monday's climactic sell-off, I was surprised at the magnitude of yesterday's sharp move higher. While such a move would be justified were a pattern shift imminent, I feel that there is far too much uncertainty in both the near- and long-term models for significant near-term upside to remain. According to my Fair Price Model, natural gas is still 12% undervalued based on current inventories, but this undervaluation flips to a small 1% overvaluation by mid-January as the storage deficit contracts down further, which will also put a cap on prices. While natural gas inventories remain historically low, the near-term prolonged period of unseasonable warmth will have done serious damage to the storage deficit by early January, likely dropping the deficit under -600 BCF. The current situation is far different from that in early November when there was a legitimate shot inventories could finish the season under 1000 BCF, provoking fears of a storage crisis. Now, that risk is effectively nil and there is even a chance that the 2019 minimum will be higher than 2018. For these reasons, I am maintaining my upside price target of $4.00/MMBTU on the commodity despite the recent model trends. Should natural gas reclaim the $4.00/MMBTU level, I would recommend taking profits on any natural gas long positions (if I had not done so already) and would look towards adding on a small speculative short position. Should the commodity continue its stomach-churning volatility and turn back lower over the next few days, I feel that prices under $3.60/MMBTU could represent a good long entry point.

The high-speed trainwreck that has been the oil trade over the past two months claimed more victims on Tuesday as WTI crashed to the tune of $3.64 or 7.3%. The commodity closed at $46.24/barrel, the lowest settlement since August 30, 2017 and down 40.0% since peaking at over $76/barrel on October 3, just 10 weeks ago. Additionally, the commodity is down over 15% since reclaiming $54/barrel after OPEC+ came to a production cut agreement following its December 6 Vienna meeting. Brent oil slid $3.35 or 5.6% to close at $56.26/barrel, allowing the Brent-WTI spread to reclaim the $10/barrel level which should, in theory, favor US exports and suppress imports. Tuesday's sell-off was driven acutely by news that Russia was increasing December output to a record 11.42 MMbbls/day, which flies contrary to planned production cuts, even if these are not slated to begin until January. This suggests that while producers may ultimately obey the letter of the law, they will do the minimum agreed upon and are undoubtedly looking after their own interests, rather than supporting the spirit of restoring global supply/demand balance. While the news out of Russia may have been the trigger for Tuesday's rout, the sector was only looking for an excuse as sentiment has been dismal for over 6 weeks amidst concern for demand destruction driven by a US-China trade war, rising US inventories and production, and continued robust Iranian output. This all being said, I feel that oil bears are overplaying their hand to the downside here. I do not believe that fundamentals support a move under $40/barrel and I expect some sort of price floor to establish itself near $45/barrel. For these reasons, at this time, I am maintaining a 2019 $60/barrel price target on the commodity.

The EIA will release its weekly Petroleum Status Report for December 8-14 this morning at 10:30 AM EDT. After Tuesday's close, the American Petroleum Institute (API) didn't do the few remaining bulls any favors, announcing that it was forecasting a +3.5 MMbbl inventory build, 4.1 MMbbls bearish versus the 5-year average -0.6 MMbbl draw and a massive 10 MMbbls bearish compared to last year's -6.5 MMbbl draw. As the Figure to the right shows, a +3.5 MMbbl build would be the fourth largest inventory build for the December 8-14 period in the full 34-year period since 1983 for which EIA data is available. Forecast refined product inventories effectively cancel each other out with a slightly bearish +1.8 MMbbl forecast gasoline build (5-year average: +1.5 MMbbls) and bullish -3.4 MMbbl distillate draw (5-year average: -0.9 MMbbls). Overall, the forecast +1.8 MMbbl Total Petroleum Inventory build (crude oil + gasoline + distillates) is modestly bearish versus the 5-year average -0.1 MMbbl draw. Of course, this is the API we're talking about, which forecast a -10 MMbbl drawdown last week compared to the EIA-reported -1.2 MMbbl draw, so take all of these numbers with a grain of salt. In the end, the official observed build or draw will likely come down to how strong exports were last week. However, with sentiment as sour as it currently is, I expect the EIA will need to report a crude oil withdrawal of some sort for the commodity to have any chance of a sustained rally this week. Check back on my Crude Oil Inventories Page HERE at 10:30 AM EDT for the official EIA storage numbers.

For a second straight day, my Oil and Natural Gas Portfolio surrendered early-session gains as oil sold off to finish the day deep in the red. The Portfolio finished Tuesday down -1.6% to reduce 2018 gains to a mere +1.1%. The losses came despite timely profit-taking on Monday of my natural gas short position and flipping to net long. I perhaps prematurely covered my 3.4% DGAZ short position on Tuesday when natural gas topped $3.75/MMBTU, realizing a +15% profit. While my stated upside price target was $4.00/MMBTU, I was concerned about the lack of cooling in the 14-day ECMWF and decided that I was not going to put a +15% 24-hour return at risk on the whims of the next computer model run. Thus, at this time, I am on the sidelines of the natural gas trade. Should natural gas rally to near or above $4.00/MMBTU, I will look to re-establish a small short position via short UGAZ while I would consider going long via short DGAZ on a break below $3.60/MMBTU. Either position would be relatively small at around 5% of my holdings until I get a better sense of how the weather pattern is evolving. On Tuesday morning's breakdown, I took the undesirable step of reducing my net long oil exposure back under my threshold of 10% (a portion of the DWT short goes towards countering my BNO short as part of a Brent-WTI spread trade). This long oil position has been a continued lead weight on my portfolio that has taken what would have been a >+10% annual gain and reduced it down to a mere +1%. As discussed above, I still believe that there remains limited downside in the oil sector and plan to continue holding this trade. Should oil resume its downtrend, however, I will continue to reduce risk by cutting my short DWT exposure. I may also consider transferring a portion of these holdings from short DWT to long UWT, as I did last month with natural gas, reducing the risk profile of a short 3X leveraged position while maintaining position size, at the expense of reducing profiting on leverage-induced decay. Click HERE for more on my current oil and natural gas holdings.

Natural gas demand will fade today as a quick-hitting colder-than-normal airmass across the Northeast quickly retreats and unseasonable Heartland warmth expands. Nearly the entirety of the Great Plains, Midwest, and Great Lakes will be at least 10F above-average today with isolated areas more than 20F warmer-than-normal. Des Moines, IA will likely rise into the lower 50s yet again today, 20F above-average, while Minneapolis, Milwaukee, and Chicago are all around 15F above-average in the mid-to-upper 40s. Along the Eastern Seaboard, most areas will rise 5F-10F from Tuesday with Boston, which struggled to break the freezing mark yesterday, reaching the low 40s today, just above their normal high. The majority of the I-95 corridor will see highs that are within 5F of average. As a result of this moderating trend and continued warmth across the Central US, today's forecast mean population-weighted nationwide temperature will rise 1.4F from Tuesday to 46.2F, a blistering 5.6F warmer-than-normal. Total Degree Days will sink to 18.4 TDDs today, 6.7 TDDs fewer than normal and the third fewest for December 19 in the last 38 years since 1981. Click HERE for more on today's temperature and degree day outlook.

Based on this forecast and early-cycle pipeline data, I am projecting a -9 BCF/day daily natural gas storage withdrawal, 3 BCF smaller than yesterday's draw and 8 BCF bearish versus the 5-year average. After falling below 2750 BCF late yesterday, projected Realtime natural gas inventories will finish today near 2742 BCF. The storage deficit versus the 5-year average will continue its hasty retreat, falling to around -667 BCF by tonight. Click HERE for more on today's projected daily storage withdrawal and Realtime natural gas inventories. Gas demand will weaken further on Thursday and Friday with daily draws of just -6 BCF/day expected. As a result, I am projecting an exceptionally bearish -52 BCF weekly storage withdrawal for the December 15-21 period, 69 BCF bearish versus the 5-year average, sufficient to take the storage deficit versus the 5-year average under -650 BCF. Click HERE for more on this week's projected withdrawal.