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Analyst: Cash-Futures Spread to Tighten, But Storage Haunts

October 5, 2009
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Low seasonal gas demand combined with limited available storage capacity will pressure cash prices, pushing the November natural gas futures contract lower, asserted a Credit Suisse analyst in a research note last Friday, arguing against a decoupling of the prompt-month contract from cash.

"Based on our conviction that the futures market will converge with the cash market over the next few weeks, we think investors should consider shorting the Nov09 contract either outright or as a spread to the Jan11 contract," wrote analyst Teri Viswanath. "We prefer the outright short to the combination spread and would set a take-profit objective at $4.05. There is a significant amount of open interest at the $4.00 strike level for Nov09 puts (which we believe is a natural downside target), so we would recommend taking profit just above this level. We would put a stop-loss in at $4.87."

November futures closed Friday's regular session at $4.718, which was 25.2 cents higher than Thursday's close. The Henry Hub cash price finished Friday averaging about $2.32, which was approximately $2.40 less than November futures.

Viswanath noted that in 2004 and in 2006 a significant basis spread remained intact for most of October. In those years the industry set records for the volume of working gas in storage, as the industry has done again this year.

"Another interesting comparison is that at the start of October in 2004/2006, the basis spread was more than $1 wide before significantly tightening toward the end of the month," Viswanath wrote.

In both 2004 and 2006 the cash market rallied to fill in the gap with futures. The impetus was demand for gas to increase storage injections and capture the basis premium. "We estimate that in 2004 and 2006 there was at least another 250 Bcf of spare storage capacity by the end of October," wrote Viswanath. "This is certainly not the case this year."

Helping to avert a market collapse this year, for one, has been a relatively heavy pipeline maintenance schedule over the past month, which has taken about 1 Bcf/d out of the market, Viswanath wrote. The curtailments along with "slightly higher demand" for gas from power generators has let cash prices drift higher over the past few weeks. However, the storage situation should force cash prices lower over the next few weeks, Viswanath wrote.

"The bottom line is that there are physical constraints that will likely inhibit the rise in cash prices during October," the analyst wrote. "We think these limitations will spill over into the November cash market. So if the basis spread does not collapse by the time the prompt contract rolls off the board, there should be ample financial incentive to underbid supplies during bidweek."

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