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La Niña: betting on the weather

US gas prices have perked up. Will the rally last or is the market setting itself up for another fall?

EL NIÑO helped knock US natural gas prices down. Now La Niña might help lift them back up.

That's what gas bulls hope, anyway. By mid-June, the Henry Hub benchmark had risen from its late winter lows of less than $2 per million British thermal units to $2.55/mBtu, its highest level in more than six months. The forward curve looks even rosier. Contracts for early 2017 are trading at just over $3/mBtu - still low by historic standards, but a welcome relief for America's hurting gas producers.

Signs that the US' record-breaking gas glut is at last easing are one source of strength. On the supply side, steep spending cuts and a dive in the rig count is taking the steam out of a decade-long run of shale-driven production growth. Gas-directed capital expenditure is down by about half this year compared to last. The rig count, which topped 1,500 in the early days of the shale boom in the late 2000s, is now just 85 - an apparent breaking point for output growth.

Production in the first half of June averaged around 70.5bn cubic feet a day (cf/d), around 1.5bn cf/d lower than a year earlier. Falling output in associated gas from tight oilfields, and costlier shale-gas plays like the Fayetteville, Barnett and Haynesville, is a culprit. But even the mighty Marcellus is showing strain, partly due to prices and partly because new pipeline capacity has been slow to come online, leaving some wells stranded. Output there has been flat, at around 16.5bn cf/d, since late last year, according to the Energy Information Administration.

Steep spending cuts and a dive in the rig count is taking the steam out of a decade-long run of shale-driven production growth

Record volumes of gas going to power plants, and in tandem with rising exports, are tipping the scales on the demand side. Gas is expected to surpass coal in the power mix for the first time ever this year, and the gas burn in May was up more than 3bn cf/d, to 26.53bn cf/d -10% more than in the same period last year. Pipeline exports to Mexico and liquefied natural gas shipments are up nearly 1bn cf/d combined over the same period.

Taken together that is a 4.5bn cf/d swing higher on the demand side at the same time as supply has dropped 1.5bn cf/d - a recipe for higher prices.

La Niña

At the crux of the bull case for prices, though, is the coming La Niña. El Niño periods are typically bearish for gas prices because they bring warmer winters to the north and wetter rainy seasons in the west - and that was certainly the case this year. By contrast, La Niña usually brings hotter summers in the north, spurring people to switch on the air conditioning, and stormier hurricane seasons that disrupt supplies followed by colder winters: a triple whammy for gas prices that could easily see prices break the $3/m Btu mark and stay there.

Weather forecasters are increasingly confident that a scorching La Niña summer and colder winter is on its way, and traders are backing those forecasts with bullish bets. The spread between spot and front-month futures heading into summer is much larger than usual, at around $0.20/mBtu, compared with the five-year average of $0.05/mBtu. That has set the stage for a volatile summer. If warmer weather comes, prices will rise along with the mercury. But if La Niña disappoints it would undercut prices, likely sending Henry Hub back towards $2.30/mBtu, if not lower.

Other factors might slow the bulls. Most important are the storage facilities still brimming from last winter's record stock build. Although gas injections into storage have been much lower than expected this spring, the US still has 3 tn cf of gas stashed away, 30% higher than the five-year average for this time of year. It will take time for those levels to burn off. As natural gas prices rise, utilities may also switch back to coal, which is at multi-year price lows. Higher prices would also trigger a supply response from producers with a deep backlog of drilled-but-uncompleted wells ready to hit the market at the first sign of a market turn.

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