Hedge Natural Gas and Electricity Based on Their Valuation

In my last Energy Alert written 10 days ago I stated we were near completion of a perfect scenario in which Natural Gas would fill a gap left behind when rates surged higher in January after the first Polar Vortex arrived. Last week Natural Gas filled the gap after the EIA weekly storage report showed an increase in storage higher than anticipated, and closed on Friday in the middle of the gap. This morning Natural Gas opened below the gap area and could be heading towards the lows reached in early November 2013 before the winter rally began.

Below is a chart of the September contract of Natural Gas, which next week will be the nearby contract:

I am surprised Natural Gas is trading below the low it reached prior to the first Polar Vortex arriving in early January, but I don’t believe it will remain below this level for long. It is possible Natural Gas will continue to decline short-term to test the low reached prior to the winter rally beginning in early November, but I don’t recommend trying to catch this exact bottom.

Based on current supply levels, Natural Gas is extremely undervalued at the present time. There are some who would argue the larger than normal weekly injections reported by the EIA is evidence producers will be able restore inventory levels to where they need to be before the winter heating season begins in November. Their argument is based on the assumption injections will continue at the same pace, which were attained with very mild weather experienced thus far this summer. But what will happen if we experience a period of extremely hot weather? Obviously injection rates would not increase at the same pace as when the weather was mild.

Should we be concerned if injection rates don’t continue at the same rate as they have been with mild weather? Based on the following points I believe the answer is a resounding yes!

1)     The EIA has said weekly injections need to be 30% larger than the five-year average to refill stockpiles to an adequate 3.4 trillion cubic feet by Nov 1^st. Last week’s larger than anticipated injection of 107 Bcf left us closer to that target, with this year’s injection rate now 28% larger than the five-year average. But consider even with the very mild weather we have experienced thus far the injection rate is still running slightly behind where it needs to be for inventory levels to reach what the EIA says will be adequate levels.

2)     But is the EIA’s estimate of 3.4 trillion cubic feet by Nov 1^st an adequate amount of supplies to begin the winter heating season? I believe the answer to this questions is no!

To answer this question let’s look at the level of storage at the start of the winter heating season for the last eight years:

2006 – 3.450 trillion cubic feet
2007 – 3.545 trillion cubic
2008 – 3.488 trillion cubic
2009 – 3.837 trillion cubic
2010 – 3.840 trillion cubic
2011 – 3.852 trillion cubic
2012 – 3.929 trillion cubic
2013 – 3.834 trillion cubic
2014 –   ?

Based on the above, even if we can maintain this year’s injection rate thus far of 28% larger than the five-year average, which is not very likely, we will still start the winter heating season with less than 3.4 trillion cubic feet in storage. As you can see from above, we will be lower than where we started the winter heating seasons from 2006 thru 2008 when the price of Natural Gas was much higher than it is today; therefore, I do not consider 3.4 trillion cubic feet to be an adequate amount of storage to start the winter heating season.

3)     Why should we be concerned about starting this year’s winter heating season with storage levels at levels not seen since 2006 thru 2008? Demand is much higher now than in 2006 thru 2008; therefore, starting the winter heating season with inventory levels this low puts us in a very tenuous position and remember if we experience warmer than normal weather in August and September inventory levels will start the winter heating season far below 3.4 trillion cubic feet.

Based on the above points if you have not already hedged your cost of Natural Gas or Electricity, I strongly recommend you take advantage of today’s rates, which are very low from an historical perspective. As I have stated many times hedgers should not try to catch the exact bottom, which 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 hedgers don’t have that luxury, since if they miss the bottom they 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