Changing Dynamics in Volatile Market

In my most recent reports, I emphasized from an historical perspective Natural Gas and Electricity rates are highly correlated to each other and both were at very low price levels. I also explained large commercial hedgers were building long positions, which historically preceded short covering rallies. As you can see in the chart below, since my May 5^th report, Natural Gas rallied to a high of $3.105 per mmbtu on May 19^th before experiencing a key reversal and declining to today’s low of $2.603 per mmbtu.

The first trust of the short covering rally I anticipated was completed on May 19^th, but I do not believe the rally is over by any means. After experiencing a key reversal on May 19^th, Natural Gas declined on low volume and with decreasing open interest for large commercial hedges. Normally low volume declines will not break below the low reached prior to the previous high volume rally; therefore, we will likely hold above the $2.443 mmbtu low reached at the end of April, and we are close to another rally in the near-term, which will take us above the May 19^th high.

After experiencing a relatively calm period for 3 months from February thru April volatility increased over the last month. Historically Natural Gas is the most volatile market traded on the NYMEX, and we are likely entering another period of extreme volatility. The reason for Natural Gas’s volatility can be traced to several main factors.

1. Limited storage capacity. When a market has limited storage capacity prices collapse when supplies grow too quickly or explode when supplies are depleted to low levels.

2. Supply/demand imbalances caused by weather extremes effecting demand. Demand rapidly increases during very warm summers or extremely cold winters, and conversely plunges during mild summers or winters. The uncertainly of the effect of weather can trigger explosive moves in both directions.

3. Difficulty in accurately measuring production and demand short-term, which causes the market to adjust to surprises in the weekly EIA storage reports. Also, the methodology used to measure supplies is not as accurate as we would like at times and the EIA needs to revise data for previous reports and it can trigger sharp changes in the direct of prices.

After the close on Friday, the EIA released its monthly Natural Gas report. In this report the EIA revised down its first quarter estimate for dry Natural Gas production and revised up its estimate for Natural Gas consumption. The EIA revised its estimate for first quarter Natural Gas production down 2 Bcf/d from 74 Bcf/d to 72 Bcf/d, and revised consumption up .7 Bcf/d from 96.3 Bcf/d to 97 Bcf/d.

This is a huge change especially considering based on previous EIA reports market participants believed Natural Gas production would steadily increase throughout 2015. But Friday’s EIA revision shows production is actually declining. Production of Natural Gas in the fourth quarter of 2014 averaged 73.3 Bcf/d, but after Friday’s report we know production in the first quarter of 2015 averaged 72 Bcf/d. The production revision was not expected by most market participants; therefore, I believe the market is primed to move higher this week. Remember large commercial hedgers still hold large long positions, and it is in their vested interest to move prices higher, and trigger a resumption of the short-covering rally.

If you have not already locked in your fixed rate Natural Gas and Electricity hedges, I recommend you do so ASAP. Rarely are hedges more attractive than at present for the following reasons:

1. Over 95% of the time since 2002 wholesale Natural Gas and Electricity rates have been higher than present levels.
2. Large commercial hedgers are holding large long positions.
3. Potential changing dynamics in production and consumption not fully factored into pricing.
4. Risk of warmer than normal summer weather or a Gulf storm hitting Louisiana or the Henry Hub region, the delivery point for NYMEX Natural Gas.

No one can predict the future, but based on the above factors, it is not wise to be short Natural Gas and Electricity at this time. Remember, if you do not have a fixed rate hedge in place, then by definition you are short the market.

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. I invite you to call one of our energy analysts to help you plan a hedging strategy appropriate for your situation.

Ray Franklin
Senior Commodity Analyst