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December 26, 2018

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Hard Times: Oil & Natural Gas Belie Their Fundamentals & Tumble In Monday Holiday Trade As US Markets Routed; Crude Oil Now Steeply Undervalued Based On Fair Pricing Model; Natural Gas Demand To Slump Through The End Of The Week Before Rebounding To Start 2019 As Colder Temperatures Expected To Return, Though Computer Models Still Divergent


6:00 AM EDT, Wednesday, December 26, 2018
Natural gas continues to struggle in its efforts to string together a pair of positive days, reversing Friday's gains and then some in Monday's Holiday-shortened trading session. The front-month January 2018 contract traded down 35 cents or 9.2%, with losses accelerating in the final hours of trading and US equities were routed, for its steepest single-session loss since November 15, closing at $3.47/MMBTU. The close was the lowest since November 2. The sell-off was driven by ongoing concerns among investors regarding an anticipated pattern shift in which the unseasonably mild temperatures the bears have enjoyed for the past two weeks revert to a colder set-up with the opportunity for arctic airmasses to sink south from Canada. The trend over the weekend had been to consistently push back the timing of this pattern change, prolonging the period of warm air and low gas demand and even increasing uncertainty as to whether the shift will happen at all. Leading this effort has been the GFS model which has been markedly divergent from its ECMWF stablemate, calling for a prolonged period of warmth into the second week of January with only intermittent, short-lived shots of colder air. Over the last 24 hours, however, the GFS has trended colder, converging towards the solution offered by the EMCWF, calling for a more sustained shot of arctic air across the Great Lakes and East for the December 31-January 5th period, and perhaps beyond. This is shown in the Figure to the right which plots the 14-day GFS and ECMWF forecast gas-weighted degree day for each run over the past week. To be fair, it's not a perfect set-up for sustained arctic air as it doesn't feature a strong Alaskan ridge allowing cold air to dive south across the central US not does it have a blocking Greenland High which would keep the arctic air in place, similar to what we saw last January that led to the record-setting -359 BCF weekly natural gas storage withdrawal. However, at minimum, the pattern would result in temperatures returning to seasonally cool levels with multiple opportunities for arctic air to at least briefly dive southward, particularly across the East.


With very bearish near-term temperatures suppressing demand, an ongoing surplus of longs likely sitting on sizable losses and looking to sell, and uncertainty regarding the temperature outlook for the next two weeks, there is undoubtedly downward pressure on the natural gas sector. However, with natural gas undervalued by nearly 20% in the wake of this latest sell-off according to my Fair Price Model and plateauing production at least temporarily narrowing supply/demand balance, I feel that the pull-back has been overdone and upside potential outweighs downside risk, especially if models trend colder. I am maintaining a $4.00/MMBTU price target although, even a single sustained arctic blast could render this conservative with peak upside likely around $4.25/MMBTU. If you are looking to go long, I strongly advise against buying the 3X long ETF UGAZ or even the 2X long product BOIL, given the elevated volatility as these products are extremely susceptible to leverage-induced decay in this environment, even in the short term. Buying UNG would be a better option while shorting the 3X inverse product DGAZ would be ideal if you can stomach the risk being short a leveraged ETF and can find shares, as the leverage-induced decay actually works in your favor. At this time, I view peak near-term downside somewhere in the vicinity of $3.15-$3.25/MMBTU should the models flip back to a prolonged period of warmth.


Meanwhile, crude oil took its sell-off to a new level on Monday, plunging in the final minutes of trading, with a 3% loss quickly ballooning into a 6.7% daily loss. WTI settled at $42.53/barrel, the lowest close since July 21, 2017, while Brent closed down $3.35 to $50.47/barrel. From its October 3 peak, WTI is now down a massive 40.5% in less than 3 months. Monday's sell-off was not driven by any news and was more likely due to underlying weakness in US equity markets that bled into the energy sector as well as a manifestation of ongoing fears regarding a global demand slowdown and rising US production. The meltdown was also likely fueled by low-volume holiday trading in which a smaller number of large sellers can have more influence than typical. However, WTI prices are now down a massive 29.5% year-over-year while US inventories are down a mere 5 MMbbls, suggesting that the sell-off is not supported by fundamentals. My newly upgraded Crude Oil Fair Price Model supports this further, using price/inventory data points from the past three years rather than just the year-over-year point. As the Figure to the right shows, per this model, WTI oil is undervalued by 29% versus a Fair Price of $60.37/barrel. Additionally, with inventories a mere 0.6 MMBBls/day loose versus the 5-year average, this undervaluation holds nearly flat as, despite fear-mongering headlines, the domestic supply/demand balance appears stable and the storage surplus seems unlikely to balloon higher near-term. For this reason, I feel that, long term, upside dramatically outweighs downside. While it is a risky trade given the historically low sentiment, I feel that crude oil is a buy at these levels. In anticipation of a successfully rebalanced market, I am maintaining an aggressive 6-month WTI price target of $60/barrel in line with my Fair Price model. For those aggressive investors, I would recommend starting with small position sizes and, as before, avoid buying leveraged ETFs while the market is as volatile as it is.


Natural gas demand will fall for a second straight day today as unseasonable warmth builds across the Midwest, Great Lakes, and Eastern Seaboard ahead of a potent Great Plains winter storm. Winter Storm Warnings are flying this morning from Kansas northward through the Dakotas and into Minnesota where upwards of 12-18 inches could fall. However, this low will be tracking south-to-north across the region allowing the southerly flow ahead of it to direct subtropical air all the way north to the Great Lakes. Even Minneapolis can expect to quickly transition to rain tonight after a brief period of snow. The largest anomalies will likely be across Missouri, Iowa and Illinois today where St Louis could reach the mid-50s, 15F warmer-than-normal while Des Moines reaches the mid-40s, more than 10F warmer-than-normal. The (relative) heat will also be on across the Deep South with El Paso, TX reaching the low 70s, Jackson, MS the upper 60s, and Little Rock near 60F, all 10F-15F warmer-than-normal. Below-average readings will be restricted to the far northern Plains, northern New England, and parts of the West Coast, although anomalies across these regions will only be around 5F below average and only in sparsely-populated regions. As a result, today's forecast mean population-weighted nationwide temperature will warm 1.2F day-over-day to 45.5F, 4.8F warmer-than-normal. Forecast Total Degree Days (TDDs) will slide to 20.2 TDDs, 5.7 TDDs fewer than normal and the 8th fewest for December 26 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 a bearish 6 BCF smaller than the 5-year average -15 BCF/day draw. The draw is also a mammoth 20 BCF bearish versus last year's -29 BCF/day daily withdrawal. By tonight, projected Realtime natural gas inventories will fall to near 2670 BCF while the storage deficit versus the 5-year average will contract to around -628 BCF. The year-over-year deficit will continue its very rapid decline, sliding to just under -550 BCF. Click HERE for more on today's projected daily draw and Realtime natural gas inventories.


Natural gas demand will continue to fall sharply on Thursday and Friday to wrap up the week as unseasonable warmth with readings 20F-30F above-average spread along the densely-populated Eastern Seaboard as far north as the Canadian border. As a result, daily withdrawals could fall to the -4-6 BCF/day range, more than 10 BCF/day bearish versus the 5-year average. However, as the Figure to the right shows, this looks to be a near-term nadir with much colder temperatures returning next week and daily withdrawals rising back to above -20 BCF/day for several days closer to each day's 5-year average. It is here, however, that forecast uncertainty increases considerably and will likely evolve over the next several days. At this time, for example, both the GFS and ECMWF models are forecasting a brief warm-up late in the first week of January that could bring daily withdrawals back into the low-teens or even single digits before another arctic airmass settles south. One thing is certain, however, and it is that 2019 will not see the same extended, record-setting cold that greeted 2018 and led to a record-setting -359 BCF storage withdrawal. Click HERE for more on near-term natural gas storage projections.