Probability of a Seasonal Rally?

In my August 15^th Energy Alert, I discussed 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.If you have not already read my August 15th Energy Alert, please do so, so you can fully appreciate the fundamental factors supporting what I am writing in today’s report.

In my Aug 15^th Energy Alert, I included the chart below, which showed the seasonal pattern of Natural Gas over the last 22 years.

The chart was built by averaging the rate over the last 22 years and I said the chart can be used as a guide for entering hedges within a certain time frame, but not to assume the seasonal low would be reached precisely during the first week of September. The seasonal low may have already been reached at the end of July or we may have one last decline to a slightly lower level later this month, but I believe the downside reward potential is minimal at this time. The goal of hedging is to lower your risk when seasonal factors favor higher rates, and hedgers should not try to catch the exact bottom.

There is no guarantee rates will make a seasonal low within the above timeframe before rallying into the spring of 2015, but based on the above seasonal pattern it is highly probable.

In this report, I will use historical data compiled since 2000 to quantify the probability of Natural Gas rallying from near present low levels. I will focus on Natural Gas, but this analysis also pertains to Electricity, which is highly correlated to the cost of Natural Gas.

Below is a chart of Natural Gas since 2000.

The eleven green arrows represent years in which Natural Gas reached a seasonal low in the fall and was higher the following spring. The two red arrows were years in which Natural Gas was lower the following spring. The one blue arrow represents a year when Natural Gas was lower the following spring, but rates were much higher during the winter and hedgers would have essentially broken even with their hedges.

Therefore, in 11 out of 14 years or 78.6% of the time hedging within this timeframe benefited hedgers. In only 2 out of 14 years or 14.3% of the time was it not beneficial to hedge at this time of the year. Hedgers by definition are risk averse; therefore, the above odds greatly favor hedging at this time. Also, in the one year in which hedging would have essentially been a wash, hedgers would have avoided the volatility experienced that year due to hurricane Katrina.

Regarding the two years in which it was not beneficial to hedge at this time of the year, there were clear reasons why the seasonal pattern did not hold form. The first red arrow occurred during the financial collapse in the fall of 2008, which adversely effected energy demand, and the second red arrow occurred when we experienced the warmest winter in over 100 years, which also had an adverse effect on energy demand.

What is the probability of either of the two above events taking place this year?

The first potential event we will consider is low demand due to a warmer than normal winter. But first it is important to note after a very mild summer and record breaking production this year the current injection rate for Natural Gas still has us on pace to start the winter heating season with supply levels approximately 10% below the 5 year moving average. I believe the risk of rates moving higher based on tight supplies is a greater concern this winter than the possibility rates may move lower.

A seasonal rally from near present levels is very likely as large hedgers protect themselves from the dual risk factors of starting the winter with tight supplies and most meteorologists forecasting a colder than normal winter. If we do in fact experience a colder than normal winter Natural Gas is positioned to spike higher than last winter. Although it is possible the meteorologists are wrong and we could experience a milder than normal winter, it should be noted several of the meteorologist’s track records have been excellent over the years and they are forecasting an exceedingly cold winter this year. And even if they are wrong, I believe our tight supply levels will keep rates from falling significantly below this year’s fall low.

The second potential event would be low demand due to a financial collapse similar to 2008/09. Obviously no one can predict such an event, and if we did unexpectedly experience a financial collapse energy demand would suffer and rates would likely decline, but given that financial collapses similar the 1930s and 2008/09 only occur once in a generation; therefore, the probability of another collapse occurring this winter would seem very remote.

The bottom line is if we do not experience an unexpectedly warm winter or financial collapse the price of Natural Gas and Electricity will be higher in the spring than it is at the present time and it would be prudent to hedge your energy usage at this time.

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