Is this a Good Time to Hedge your Energy Supply?

An historical view of the cyclical nature of natural gas and electricity prices

The purpose of this article is to help you view natural gas and electricity prices from a historical perspective which clearly shows their cyclical nature, and to provide some insight into today’s market. We discuss natural gas and electricity together due to their high price correlation, but our analysis primarily focuses on natural gas since it is actively traded on commodity exchanges; therefore, we have access to a large amount of historical data on the subject.

The cyclical pattern of natural gas is primarily related to supply and demand factors. When prices are high, producers are motivated to increase production. When demand declines, prices collapse. Conversely, when prices are low, suppliers are motivated to decrease production (as profits are lower). Demand increases until prices spike higher. Price extremes are reached based on the market’s adjustment to supply/demand imbalances.

Over the last four years, production has increased due to hydraulic fracking. This increase in production has led to lower prices. But lower prices, along with the closure of coal-fired plants, have substantially increased demand. This will inevitably lead to higher prices. The ongoing struggle between increased production and demand will invariably lead to increased volatility. This is primarily due to the limited storage capacity of natural gas, which causes wild swings in prices when either supply or demand gains the upper hand.

The chart below reflects high volatility of natural gas from 2000 thru 2009:

Prior to 2000, there was ample storage for natural gas to accommodate changes in seasonal demand. Thus prices were relatively stable. But as demand increased, prices became increasingly unstable from 2000 through 2009. In 2012 prices collapsed due to the combination of increased production from fracking and low demand due a very warm winter. But, as previously mentioned, demand for natural gas has steadily increased and in winter 2013/14, which was colder than normal, prices again surged.

That winter was cold, but we have had cold winters before without experiencing the record breaking weekly drawdown of natural gas. The reason was simple. Demand for natural gas is much higher now than it was 10 years ago, but our working storage capacity has not kept pace, and increased pipelines have not been sufficiently built to deliver natural gas to where it is needed. Over the next ten years both production and demand for natural gas will continue to increase, and infrastructure limitations will lead to extremes in prices.

The chart below shows price extremes reached due to events affecting supply and demand since 2002.

Rates surged when we experienced a colder than normal winter in 2002, hurricane Katrina in 2005 and a hotter than normal summer in 2008. Conversely, prices collapsed when demand decreased due to the financial collapse in 2009, warm winter of 2012 and 2013’s milder than expected winter.

We are again entering a volatile period in the energy markets. Determining where rates are headed from a cyclical and historical perspective will be vital to developing effective hedging strategies.

This historical perspective should help you understand why, based on present cyclical and historical price patterns, the upside risks are considerable at this time. When your cost of natural gas or electricity is not hedged, you are at risk in these markets. Over the last 13 years, the price of natural gas has been higher than the present levels more than 90% of the time.

Do you really want to be at risk when a market is at the lower end of its trading range? If your answer is, “No”, then you understand why we recommend hedging your cost of natural gas and electricity at today’s low historical price levels.

North American Energy Advisory specialists can help you with your energy hedging decisions, drawing on our extensive knowledge of the market, its history and its current state.

Ray Franklin
Senior Commodity Analyst