Risk/Reward Analysis from an Historical Perspective

In this Energy Alert I will review my analysis of Natural Gas and Electricity rates over the last year and where we are at the present time from a historical perspective. I refer to Natural Gas and Electricity together because of their high price correlation.

In my 6/21/13 Energy Alert I stated the 10-year low Natural Gas reached in the spring of 2012 was the end of a four-year bear market, and we were in the early stages of a long-term bull market similar to what took place from 2002 to 2008. I will refer to the weekly chart below covering the Natural Gas’s price action from 2002 to the present to show where we are from a historical perspective.

Over the last year I repeatedly warned we were heading into a period of high volatility similar to the bull market in Natural Gas from 2002 to 2008. As you can see in the above chart Natural Gas trended higher from 2002 to 2008 as shown by the red trend line. Bull markets are characterized by extreme volatility with a series of higher highs and higher lows.

Also, as you can see in the above chart the initial 24 months of the bull market starting in 2002 was very similar to how Natural Gas has traded since reaching a 10 year low in the spring of 2012.This is precisely the type of trade action I warned was forthcoming and most importantly I believe the way Natural Gas traded from 2004 thru 2008 is a harbinger of the future price activity we should anticipate for Natural Gas over the next few years. The key to effective Natural Gas and Electricity hedges will be their timing in light of the risk/reward for hedging versus riding the market. The fundamentals for Natural Gas are changing and must be accounted for in formulating hedging strategies.

In my 8/16/13 Energy Alert I stated some believe fracking technology created a new paradigm in Natural Gas, and prices will remain low for many years, but I believe this view is shortsighted. The market has a way of correcting imbalances with the dynamics of low prices increasing demand for Natural Gas and thereby overwhelming increased production.

The following is a brief summary of factors leading to increased demand:

1. A trend is in place for new power plants to utilize natural gas instead of coal, nuclear power and renewable resources. Due to regulatory restrictions introduced by the EPA and Obama Administration coal-fired plants are becoming increasingly more expensive to run and natural gas-fired plants are much cheaper to build than coal, new renewable or nuclear plants.

2. Since 2010, 150 coal-fired plants have closed representing approximately 25 gigawatts of coal-fired power and with stricter regulations on coal on the horizon, more coal-fired plants closing are anticipated in 2015 thereby increasing demand for Natural Gas.

3. Industrial demand for natural gas is increasing due to its cost advantage to other higher-cost energy sources.

4. Increased exports of liquefied natural gas (LNG) to Europe and Asia.

5. LNG exports to Mexico are expected to increase dramatically with the completion of new proposed natural gas pipelines. The increased demand from Mexico could eclipse all production growth in the United States during this period.

6. Increased demand in the transportation industry is anticipated as technology is developed to utilize natural gas instead of crude oil products.

The above is not an all-inclusive list of factors leading to increased demand for Natural Gas, but when you compare the factors supporting increased demand versus the modest estimates of increases in production, it was clear the market would correct the abundant supply imbalances of 2012/13. Also, as I discussed in my 4/8/14 Energy Alert our infrastructure has not kept up with increases in supply/demand, which was a major factor behind the surge in Natural Gas and Electricity rates this past winter.

Why has our infrastructure not kept up with supply/demand needs of our nation?

There are 2 primary reasons:

1. Higher prices lead to higher profits -The high prices this winter increased bottom line profits for suppliers of Natural Gas.

2. High cost of building new infrastructure – New infrastructure is very expensive and would result in lower prices. What motivation do suppliers have to spend a large amount of money on new infrastructure, which would likely lead to lower prices?

This is the same reason why although we have ample supplies of Crude Oil, prices continue to rise. We lack adequate refineries to deliver the end products of Crude Oil, which are Gasoline and Heating Oil to consumers. Major oil companies have no incentive to spend money on new refineries, which would also result in lower prices. This truth has been known for years, and yet there remains a dearth in the construction of new refineries. I believe similarly the Infrastructure of Natural Gas will lag behind supply/demand resulting in surges in prices when we experience a colder than normal winter or warmer than normal summer.

Obviously the extremely cold weather experienced this past winter accelerated the correction of supply imbalances of Natural Gas of 2012/13, and we are now facing critically low Natural Gas storage levels. The EIA announced today an injection of 114 Bcf and inventories of Natural Gas are now at 1,380 Bcf, which is 40.1% below the five-year moving average of 2,302 Bcf leaving us still with a deficit of 922 Bcf. Although an injection of 114 Bcf sounds like a large number, seasonally it is not unusual. During this time of year demand is very low and large injections are to be expected. In 2013, builds ranged from 88 to 111 Bcf from mid May to the end of June. Therefore, even if we see triple-digit injections over the next month, it will not have a large impact on the deficit.

The question is where are rates likely going from here and what is the appropriate hedging strategy to implement at this time?

In my 5/8/14 Energy Alert I said injections should increase over the next month prior to the summer cooling season taking effect, and it is possible the market may experience a shallow pullback. But it is important to understand due to the risk factors discussed in that report any pullback over the next 4 to 6 weeks will be shallow and the risk/reward of delaying securing fixed rates may not be in your best interest. The key to determining appropriate hedging strategies is knowing where a market is trading from a risk/reward perspective.

The most important variable effecting demand over the next 3 months will be the weather. No one can predict with 100% accuracy the temperate range and storm activity for this summer. But based on recent price activity we can estimate a range for prices if we have a mild or hot summer or God forbid a major storm disrupts production or transport of Natural Gas. After trading commodities for 34 years I have found the key to successful trading is determining the risk/reward potential for each trade.

If we experience a mild summer I believe natural gas could decline moderately to test the lows reached prior to the winter rally near $3.70 per MMbtu and electricity rates would marginally decline. But if we experience a warmer than normal summer our low storage levels will not be rebuilt at a rate needed prior to next winter’s heating season and natural gas rates could surpass this past winter high of $6.49 per MMbtu. Therefore, the risk/reward ratio is approximately 3 to 1 against delaying reserving your next hedge.

The 5 year chart of Natural Gas below will help put into perspective the present risk/reward situation for Natural Gas.

The green arrow shows rates declining from present levels to the fall low in the forward markets near $3.70 MMbtu due to a mild summer, while the red arrow shows rates rising towards this past winter’s high near $6.49 MMbtu if we have a warmer than normal summer.

It is important to note if Natural Gas continues to follow the bull market pattern of 2002 thru 2008 than the trend of prices will continue higher over the next few years and last winter’s high of $6.49 MMbtu will be exceeded and the risk/reward ratio will be greater than 3 to 1 against delaying reserving your next hedge from present price levels.

Not every client’s risk tolerance and hedging strategy is the same, but we trust the above report will help you put into perspective the risk/reward opportunities at this time. We invite you to call one of our energy analysts to help you plan a hedging strategy appropriate for your situation.

Ray Franklin
Senior Energy Analyst