Natural gas prices tend to be driven over the short term by changes in weather and the impact this has on demand. In the long run, supply and demand dynamics will tend to shape the price environment. At present, the market is facing significant pressure on both fronts and while we think much of the bad news is priced into the commodity as we head into 2016, we would underweight natural gas stocks as cash flows are likely to be under significant pressure throughout the year.

Commodity forecasts
Oil (WTI $/bbl) 52.03 62.03
Natural Gas ($/mmBtu) 2.50 3.00
Gold ($/oz) 1,200 1,250
Copper ($/lb) 2.00 2.25
Corn ($/bu) 4.00 4.09
Wheat ($/bu) 4.86 5.30

Source - RBC Capital Markets forecasts (oil, natural gas, gold, and copper), Bloomberg consensus forecasts (corn and wheat)

Abnormally warm weather is being attributed to the effects of El Niño, which is a disruption of the ocean-atmosphere system in the tropical Pacific. El Niño events are generally classified by an increase in surface sea temperature of +0.5 C above normal. Since 1950, there have only been seven El Niño events that have been “strong” events (+1.5 C above normal), with only three reaching a “very strong” indicator (+2.0 C). The most recent very strong year was the 1997–98 “super” El Niño.

As compared to other El Niño weather patterns observed since the early 1970s, the current experience is the third-strongest thus far. During the 1997–98 “super” El Niño, winter temperatures were the second-warmest on record. In that winter, natural gas demand for residential and commercial heating was down 5%–6%. Prices for the commodity dropped to $2/Mcf, down by $0.50–$0.60/Mcf from the prior-year average, and remained at those levels for more than a year.

Amid the gyrations of unpredictable weather, the steady rise of low-cost natural gas from Appalachia continues. Production in the region has increased dramatically over the past five years, from 2 Bcf/d in 2010 to its current level of 19 Bcf/d, which is significant in the context of total U.S. natural gas supply of about 75 Bcf/d in 2015. Production growth has been so rapid that the primary constraint has been pipeline capacity to take it away. RBC Capital Markets projects there is an inventory of over 1,000 wells that have been drilled but are not yet flowing because of insufficient pipeline capacity. As additional pipes are brought on-stream, volumes from Appalachia should expand to 21 Bcf/d by year-end 2016.

With warm weather patterns from El Niño emerging in force, as well as continued supply growth from Appalachia, we would expect the commodity price to face significant headwinds in 2016 and would take an underweight stance on related equities. Natural gas prices have recently bounced from lows just under $2/Mcf. We see $2–$3/Mcf as a reasonable price expectation for the year ahead.

Historical deviations from the mean sea surface temperature

Pacific Ocean surface temperatures are well above historical norms, indicative of a strong El Niño effect.

Source - National Oceanic and Atmospheric Administration (NOAA)

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