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The February Blues
Toronto: February 24, 2014
By John Stephenson

With the first two months of the year almost in the can, we’ve been buffeted by a barrage of mixed indicators.  The weather in North America has been abnormally brutal, emerging markets have been volatile, China credit fears are front and center and the Fed is continuing to taper.  Against this backdrop gold and bonds have been the outperformers so far this year, while stocks have lagged.  Last year’s strong rally in stocks is beginning to appear like a distant memory.

Defensive names have outperformed cyclical names in the U.S. since the start of the year, but in Canada and Australia, cyclical names are helping power those markets to local currency gains on the year.  Gold has rallied strongly this year, defying the skeptics, while natural gas has soared, lifting the fortunes of gas producers along with them.  In Europe it is the periphery (Portugal, Spain, Greece and Italy) that are experiencing solid positive gains so far this year.  Despite the general shit toward more defensive names in the U.S. the shift is not all that pronounced.  Utilities have done well of late, but that is largely because of the rally in bonds, while Telcos and Staples have lagged the overall market.

After languishing for years because of industry oversupply and weak demand, natural gas prices have risen to multiyear highs in recent weeks amid frigid weather in North America.  Natural gas surged above $6 per million British thermal units this past Wednesday, to its highest levels since the end of 2008.  The harsh winter has helped buoy natural gas prices as heating demand has eaten into natural gas inventories.  The heating degree days (the number of degrees, per day, that the temperature is below 65 Fahrenheit) for 2014 is 13 percent above last year’s count.  Inventories in the U.S. gas storage facilities are at their lowest level in a decade for this time of year and 33 percent below a year ago levels.

The surge in natural gas could easily be written off as a weather-related boom, but growth in production has flattened in the last 18 months suggesting that the rally in gas and gas producers could be here to stay.  After years of strong production growth, driven by the revolution in shale gas—drilling activity has fallen off a cliff.  The number of drilling rigs working in U.S. natural gas fields is less than a quarter of the count in 2008, and only about a third of the levels in 2011.  A potent combination of high costs, rapid depletion and years of low natural gas prices has seen natural gas drilling slump to the lowest level in 20 years.  Many producers have re-focused their bets on the more lucrative oil prospects over the past several years.

With drilling activity at such low levels it will be hard for natural gas inventories to bounce back to previous levels once the winter heating season is done—suggesting that we may enter next winter understocked.  With older shale plays declining after years of aggressive exploitation and producers favoring light oil over new shale gas plays because of the high cost of drilling, we may be entering a new era of tighter natural gas supplies.

And that’s unquestionable bullish for natural gas prices over the next few years.  Last week, Canadian Natural Resources (CNQ—TSX), an oil sands producer, snapped up Devon Energy’s Canadian natural gas properties in a $3.1 billion bet on gas.  What makes this transaction even more remarkable is that it was an about-face for the company, which a month earlier yanked its plan to sell or partner on some of its British Columbia natural gas lands.

While I believe that the materials and energy sectors are starting to look attractive, I think the easy money for now has been made in the natural gas trade.  The next leg up for the natural gas producers will be in the second tier names, the ones with highly levered balance sheets and higher-than-average operating costs.  But since natural gas is a commodity that is seasonal, I will be looking to start buying some of the first tier names again, when September rolls around and another winter looms

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