Long-term perspective of Natural Gas & Electricity

In this Energy Alert I will discuss Natural Gas and Electricity from a longer-term perspective along with appropriate strategies for today’s environment. I refer to Natural Gas and Electricity together because of their high price correlation.

I will focus on the following 5 points:

1. The ramification of demand for Natural Gas being higher in 2014 than in 2013.
2. Natural Gas and Electricity are in backwardation
3. We are entering a period of high volatility similar to 2002 to 2008.
4. Why a period of high volatility is anticipated.
5. Hedging strategies for volatile markets.

1. The ramification of demand for Natural Gas being higher in 2014 than in 2013.

We know demand for Natural Gas will be much higher in 2014 than it was in 2013 based on the need to replenish low storage levels. The storage situation has continued to worsen with the EIA announcing last week inventories of Natural Gas were at 822 Bcf, which is 54.7% below the five-year moving average of 1,814 Bcf. We have never started the injection period with a deficit this high.

The injection period for Natural Gas begins in April and we are nearly a trillion Bcf below the five year moving average. Natural Gas suppliers need to increase production nearly 5 Bcf per day more than last year to replenish supplies before the coming winter heating season. Many believe we will produce natural gas at a record pace and refill storage, but this belief may be overly optimistic. There is no arguing fracking technology has increased the production of natural gas, but the demand for natural gas has also increased dramatically.

Demand for Natural Gas has increased year over year for the last 10 years, and demand will likely be substantially higher year over year in 2014. The summer of 2013 was very mild, which is why Natural Gas declined from May thru Aug 2013. But if we experience a warmer than normal summer in 2014 as projected by meteorologists, demand for Natural Gas will be much higher and the winter rally we experienced this year could be dwarfed by a rally this summer.

2. Natural Gas and Electricity are in backwardation

Natural Gas and in most regions Electricity are experiencing backwardation. By definition backwardation occurs when further out contracts are sold at a lower price than nearby contracts. Many traders mistakenly believe this is a bearish configuration, but over the last year I repeatedly warned we are in the early stages of a bull market similar to 2002 to 2008. During this period Natural Gas and Electricity markets were also in backwardation and hedgers who hedged longer-term benefited by the lower rates further out in the pricing matrix.

The bottom line is Natural Gas prices in the forward markets starting in April 2015 are close to where they were in April 2013; therefore, hedgers today have an opportunity in the forward markets to hedge Natural Gas and Electricity prices for 2015 at close to 2013 price levels.

3. We are entering a period of high volatility similar to 2002 to 2008.

As I warned in my Energy Alert written 12-months ago on 4/6/13, due to factors influencing supply and demand we are entering a period of high volatility similar to 2002 to 2008.

In my 4/6/13 Energy Alert I referred to the 15 year chart of Natural Gas below:

At that time, I stated no one knows when the energy markets will again spike upward, but obviously the upside risk is substantial. If you have not already hedged your cost of Natural Gas or Electricity, then whether you realize it or not, you are short these markets. Look at the above chart and ask yourself…do I want to be long or short this market. I believe the answer was obvious last year and with prices close to where they were a year ago the answer is the same today.

4. Why a period of high volatility is anticipated.

We are entering a period in which technological advances has increased production of Natural Gas in the United States leading to lower prices, but conversely lower prices increased demand leading to higher prices, and both factors lead to increased volatility. Some believe the new reserves of Natural Gas available through fracking will allow production to meet increased demand and keep prices low for the foreseeable future with low volatility. But they are missing one very important factor.

Although it is true we have a large amount of new reserves available due to fracking, we have not improved our infrastructure to deliver Natural Gas to where it is needed. This winter in New York prices for Natural Gas surged above $100 per MMbtu. New York is next door to the Marcellus Shale reserves, which has the largest working reserves in the U.S., and yet New York experienced some of the highest Natural Gas prices in the country. How could this happen? The answer is our infrastructure did not keep up with increases in supply and demand, and most importantly there is no reason to believe the situation will improve anytime soon.

This winter was cold, but we have had cold winters before without experiencing the record breaking weekly draws of Natural Gas we had this winter. The reason for this is simple. Demand for Natural Gas is much higher now than it was 10 years ago, but we have not substantially increased our working storage capacity, nor increased pipe lines to quickly deliver Natural Gas to where it is needed. Therefore, in New York instead of being able to access Marcellus Shale reserves, they were forced to import Natural Gas from refineries in the Gulf.

Why has our infrastructure not kept up with supply/demand needs of our nation?

There are 2 primary reasons:

1. Higher prices lead to higher profits -The high prices this winter increased bottom line profits for suppliers of Natural Gas.
2. High cost of building new infrastructure – New infrastructure is very expensive and would result in lower prices. What motivation do suppliers have to spend a large amount of money on new infrastructure, which would likely lead to lower prices?

This is the same reason why although we have ample supplies of Crude Oil prices continue to rise. We lack adequate refineries to deliver the end products of Crude Oil, which are Gasoline and Heating Oil to consumers. Major oil companies have no incentive to spend money on new refineries, which would result in lower prices. This truth has been known for years, and yet there remains a dearth in the construction of new refineries. I believe similarly the Infrastructure of Natural Gas will lag behind supply/demand resulting in surges in prices when we experience a colder than normal winter or warmer than normal summer.

5. Hedging Strategies for volatile markets.

The key to successful hedges is timing and this is especially true in volatile markets. It is important not to chase markets when they spike higher, and patiently wait for the market to pullback. Our consultants are trained to contact our clients when it is timely to either initiate new hedges or renew present hedges.

Our consultants utilize a variety of strategies in volatile markets:

1. When the market spikes higher and it is appropriate based on the utilities tariff rate, they will recommend a short-term fixed hedge to serve as a bridge while waiting for the market to pullback.

2. During pullbacks in regions experiencing backwardation they will recommend a longer-term fixed hedge when further out contracts are selling at a lower price than nearby contracts, which is the case today.

3. For large commercial accounts our consultants have an array of products available such as LMP + Fixed Adder, Block & Index, and other sophisticated products along with fixed hedges as described in 2 & 3.
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