Factors Supporting Seasonal Buying Opportunity

In my July 21^st and July 25^th Energy Alerts, I explained why based on current supply levels, Natural Gas is extremely undervalued at the present time, but we may have one last decline towards $3.60 per million BTUs. If you have not already read my last 2 Energy Alerts, I would encourage you to do so, so you can fully appreciate what I am writing in today’s report.

In this report, I will discuss the seasonal factors supporting hedging your cost of natural gas and electricity at this time. All commodities follow seasonal patterns and Natural Gas and Electricity are no exception.

Seasonal commodity patterns are formed based on 2 primary factors:

1)    Fundamentals.

2)    Objective of Hedgers.

Fundamentals for Natural Gas:

I will be focusing on Natural Gas, but this analysis also pertains to Electricity, which is highly correlated to the cost of Natural Gas. The primary quantitative tool I use to evaluation a commodity’s fundamentals and valuation is their supply/demand data. The price of a commodity is greatly influenced by inventory levels. When inventory levels are low prices tend to be higher than when inventory levels are high.

Since the beginning of this year I warned inventory supplies of Natural Gas were lower than normal. In my January 3^rd Energy Alert I stated Natural Gas’s inventories were 9% below the five-year average; therefore, I said we were entering the winter heating season with relatively low inventory levels, and from a fundamental perspective the risk of higher prices were a very real possibility. I am sure you are aware what took place this winter when colder than normal temperatures triggered a surge in Natural Gas and Electricity rates.

I am very concerned that supply levels at the end of this year’s injection period will be well below last year; therefore, from a fundamental perspective the risk of higher prices from present levels is very high. In my July 21^st Energy Alert, I said Natural Gas inventory levels will likely be near 3.4 trillion cubic feet at the end of this year’s injection period on Nov 1^st, which is not an adequate level of supplies for this time of the year. I pointed out 3.4 trillion cubic feet by the end of this year’s injection period would be lower than the ending injections levels from 2006 thru 2008 when the price of Natural Gas was much higher than today. Therefore, from a fundamental perspective Natural Gas is extremely undervalued at the present time.

Objective of Hedgers:

Natural Gas and Electricity hedgers enter into contracts to reduce the risk of adverse price movements. The motivation to hedge is greatest when prices are lower than normal based on supply/demand fundamentals and prior to periods of uncertainly.

At the present time both factors favor entering hedgers.

Our inventory levels at the end of this year’s injection period will not be adequate and based on the historical data I already presented it is clear Natural Gas and Electricity rates are low from a historical perspective. But the timing of entering hedges is based on an additional factor, the uncertainty of future events. No one knows whether we will experience a warmer or colder than normal winter this year, but when rates are low experienced hedgers enter their hedges well in advance of the event. Remember, hedgers are risk averse and they don’t care if they enter their hedge a little early.

Over the last 22 years, Natural Gas formed a clear seasonal pattern in which it made an important season low near the end of the summer and near the end of the winter prior to rallying strongly off the lows. The chart below shows the seasonal pattern of Natural Gas over the last 22 years.

This seasonal pattern shows that hedgers enter their positions prior to the event and close their positions while the event is taking place. There is an old trading adage ”buy the rumor and sell the fact”. Positions are purchased prior to the event taking place and sold while the event is taking place. Based on the above seasonal pattern it is clear we are now within a window for entering hedges. I am not saying based on the above chart we should anticipate the low for Natural Gas will occur in the first week of September. The chart was built by averaging the rate over the last 22 years and should be used as a guide for entering hedges within a certain time frame.

For example, it is documented the highest probability for a hurricane making landfall in the U.S. occurs on September 10^th, but we know a hurricane can arrive on August 15^th or Oct 15^th. In the same way, the highest probability of Natural Gas making its seasonal low this year would be in the first week of September, but that does not mean the seasonal low did not already occur on July 28^th at $3.725 per million BTUs, or later in September near $3.60 per million BTUs.

Another important point to glean from this seasonal pattern is Natural Gas rates in the fourth quarter of 2014 will be much higher than right now. Therefore, I don’t advocate trying to catch the exact bottom. As I have stated many times this is the role of a speculator. If a speculator misses the exact bottom it does not cost them anything except opportunity cost, and opportunity cost is not as expensive as lost capital. But as a hedger you don’t have that luxury, since if you miss the bottom you are inherently 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 Energy Analyst