Long-Term Perspective of Natural Gas and Electricity

In our last Energy Alert we stated if there was a period of milder than normal weather in August, natural gas could briefly trade below the 200-Day Moving Average, but based on our premise that we are in the early stages of a bull market the time spent below the long-term trend would be short lived and viewed as an opportunity to initiate or extend hedges.

The weather since our 7/26/13 Energy Alert was much milder than normal in the high usage areas (Northeast and Midwest); therefore, as you can see below natural gas has traded below the 200-Day Moving Average.

2 year NG chart

The break in prices is the largest since the bear market low reached in the spring of 2012 and appears substantial, but the 15 year chart below puts into perspective the size of the recent correction in natural gas from a long-term perspective.

NG monthly continuation chart
If you look at both charts you can see the correction we predicted would take place is minor from a long-term perspective, and does not change our view that we are in the early stages of a long-term bull market. On our Historical Data page (click here), we discuss natural gas and electricity prices from a cyclical and historical perspective. On this page we discuss the psychology behind cyclical patterns. To put it simply when prices are low demand increases and production decreases, while conversely when prices are high demand decreases and production increases.

There are some who believe fracking technology has created a new paradigm in natural gas, and prices will remain low for many years. We believe this view is shortsighted. The market has a way of correcting imbalances and the dynamics of low prices will increase demand for natural gas and eventually overwhelm increased production. A brief summary of factors leading to increased demand are:

1. Increased exports of liquefied natural gas (LNG). At the present time there are only two fully approved LNG export terminals on line, but on August 7th, DOE and the Obama Administration approved a third LNG export terminal in Lake Charles, and there are 18 pending applications to export LNG. It is anticipated the other 18 projects will be approved over the next 3 years.
2. LNG exports to Mexico are expected to increase dramatically by the end of 2014 with the completion of proposed natural gas pipelines. The increased demand from Mexico could eclipse all production growth in the United States during this period.
3. A trend is in place for new power plants to utilize natural gas instead of coal, nuclear power and renewable resources. Due to regulatory restrictions introduced by the EPA and Obama Administration coal-fired plants are becoming increasingly more expensive to run and natural gas-fired plants are much cheaper to build than coal, new renewable or nuclear plants.
4. Increased demand in the transportation industry is anticipated as technology is developed to utilize natural gas instead of crude oil products.
5. Industrial demand for natural gas is increasing rapidly due to its cost advantage to other higher-cost energy sources.
The above is not an all-inclusive list of factors leading to increased demand, but when you compare the factors leading to increased demand versus the modest estimates of increases in production in natural gas, it is clear the market is quickly moving to correct the abundant supply imbalances of last year.

No one knows whether the recent correction in natural gas has further to go before resuming its upward trend to higher prices, but the correction could end abruptly with a 7 to 10 day forecast for warm weather or a wave developing off the African coast. Based on the above factors we do not believe the risk/reward benefit of trying to catch the exact bottom is wise. We leave that for the speculators who can stand aside and hope to nail the exact bottom. If they miss the bottom it does not cost them anything except opportunity cost, and opportunity cost is not as expensive as lost capital. But hedgers do not have that luxury, since if they miss the bottom and are not hedged 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. We 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