Characteristics of a Major Bottom

Over 40 years of trading I have observed major bottoms are identified when the following 2 conditions are present:

1. Unsustainably Low Prices.
2. High level of Negative News.

In today’s report, I discuss these 2 characteristics of a major bottom and why in 40 years of trading I seldom have seen conditions more suitable for a major bottom in Natural Gas and Electricity than today:

1. Unsustainably Low Prices – Prices become unsustainably low when they drop below the cost of production. The cost of production is based on many factors, but since over the last year most companies producing Natural Gas have reported losses, it is clear the cost of production was higher than the average price they received over the last year.

Also, it is important to note, the very mild weather we are experiencing this winter decreased the demand for Natural Gas and prices are near a 17-year low; therefore, the losses of Natural Gas producers are increasing, and many are in danger of bankruptcy.

This is why over the last 20 years when prices fell to near present levels, rates were higher on average the following 12, 24 & 36 months. The weaker companies do not survive, and the ones who do survive decrease production leading to higher prices. The chart below shows the 7 times over the last 20 years, Natural Gas prices dropped below $2.00 per MMbtu:

As you can see in the above chart every time prices dropped below $2.00 per MMbtu, rates were higher on average the following 12, 24 & 36 months. It should also be noted the longer prices stay low the higher they will go! This is a byproduct of the weaker companies being forced out of business thereby decreasing competition, and the surviving companies are highly motivated to increase prices to make up for lost profits accrued while prices were low.

2. High level of Negative News – Over the years, I observed major bottoms are reached when there is a high level of negative news. Negative news is the reason prices were forced lower, but when the level of negative news reaches historical extremes, prices invariably are near a multi-year low. Examples of historically extremely negative news are “The highest level of production in history” or “The highest level of storage in history” or “One of the warmest winters in history is lowering demand for energy”.

As I write this report, all of the above negative news events are in play. The most recent example of the same combination of extremely negative news took place in 2012. The winter of 2011/12 was the warmest in 100 years; therefore, storage levels were the highest in history, and due to new fracking technology production increased by the largest amount year over year in history.

Logically you would have thought ending the winter of 2011/12 with the highest storage level in history for that time of the year, and experiencing the largest increase in production in history over the next 12-months would result in lower prices. But as you can see in the 12-month chart of Natural Gas in 2012 below prices increased dramatically after briefly trading below $2.00 per MMbtu.

When the news becomes very negative from an historical perspective, all of the bad news is now factored into the price, and rates are primed to move higher!

The take away from this analysis is the conditions supporting a major bottom in Natural Gas are in place, and although prices could go slightly lower in the near-term, it is highly likely the average price of Natural Gas will be significantly higher over the next 12, 24 & 36 months.

This report focuses on Natural Gas rates, but my analysis also pertains to Electricity. Natural Gas is now the largest source of energy for the generation of Electricity in many regions; therefore, Natural Gas and Electricity rates are highly correlated.

Remember the longer prices stay low the higher they will likely go! Therefore, if your hedge contracts expire within the next 18-months, we strongly recommend reserving blocks of Natural Gas and Electricity to be available when your present contracts expire.

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
727-400-3170