Summer Is Looking Bright for Oil Prices

Seasonal demand dynamics are looking up for oil prices. But there are downside risks to U.S. natural gas: Higher oil prices are an incentive for more shale oil drilling, which increases the level of associated natural gas production when there is weakening seasonal natural gas demand. Technicals for natural gas prices have also weakened, and shale oil drilling is poised to accelerate further this spring and summer, given the upside risks to crude oil prices as the summer driving season approaches.

For oil drillers, natural gas is a critical part of an exploration-and-production company’s valuation. But natural gas prices often are not a critical part of the financial decision to drill an oil well. As long as oil prices are supported, drillers will be producing gas, even if prices remain relatively low -- or fall further. This is called associated natural gas, because it is “associated” with the oil that drillers really want to pump out of the ground. As a result, higher oil prices during the driving season could weigh on natural gas prices, because more natural gas will be produced from additional shale oil well drilling.

The partial implementation of production cuts by members of the Organization of Petroleum Exporting Countries has supported oil prices enough to give an incentive for additional U.S. shale drilling, sending oil rig counts higher by more than 87 percent since May 2016. And the short-term energy outlook report from the U.S. Energy Information Administration this month highlighted that increased oil drilling is expected to send U.S. oil production to a 48-year high. The report was understandably bearish for crude oil prices, but natural gas prices rose the day it was released. Distracted by near-term risks of winter weather, some traders may be missing the fact that more shale oil drilling will increase natural gas production even as demand is seasonally weak.

U.S. natural gas inventories are currently high at almost 2.6 trillion cubic feet. That is 1.8 percent above the five-year moving average, but 11.3 percent below the levels reached last year that engendered a collapse in natural gas prices to $1.64 on March 3. That means there is likely to be more price support for natural gas in the first and second quarters than there was last year, thanks to the lower year-over-year level of inventories. But there are still downside risks to natural gas prices -- especially if oil prices rise further and crude oil drilling activity increases further.

In addition to relatively high natural gas inventories and the prospects of more associated gas production, moving average, relative strength and volume technicals have been bearish for natural gas since the New Year. On Feb. 3, the price of natural gas closed below the 130-day moving average -- a critical technical support over the past three years. This was a very bearish signal to the market, and the price of natural gas has fallen further since Feb. 3, despite a recent blast of winter weather.

 Winter is almost over for the so-called Henry Hub natural gas prices on the NYMEX, since that contract closes on Feb. 24, 2017. And the imminent onset of the refinery buying ahead of the U.S. summer driving season presents additional bullish risks to WTI crude oil prices -- and bearish risks to natural gas prices. Focus on the U.S. summer driving season is likely to increase after the April WTI crude oil contract becomes the front month on the NYMEX after the March contract closes on Feb. 21, 2017. Natural gas prices are poised to fall further, and the declines in natural gas prices since the close below the 130-day moving average on Feb. 3 may be just the beginning of a larger seasonal decline.

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