Ramifications of Natural Gas Supplies Below 5 year Moving Average

My reports focus on Natural Gas because it is now the largest energy source for the generation of Electricity; therefore, Natural Gas and Electricity rates are highly correlated.

In my Nov 28^th Energy Alert, I delineated 3 reasons Natural Gas prices would continue to increase in the present price cycle. If you have not read this report, I recommend you click on the Nov 28^th Energy Alert hyperlink included in this paragraph, and review it prior to reading today’s Energy Alert.

In my Nov 28^th report, I warned storage levels for the following 4 weeks were expected to decline sharply, and if the estimates were correct, storage would quickly approach the 5-year moving average by the end of December. The estimates were in fact conservative, and tomorrow the EIA will announce Natural Gas storage is now below the five-year moving average for the first time since the week ending 5/19/15.

The question is, what are the potential ramifications of this event?

In my last report, I pointed out, cycles normally do not end until an event leads to the culmination of the cycle. For example, the cycle beginning in the spring of 2012 did not end until we experienced the brutally cold winter of 2013/14, which lead to the final highs of that Bull Market cycle.

The brutally cold winter of 2013/14 drew storage levels far below the 5-year moving average triggering the final high of $6.493 MMbtu in the March 2014 futures contract.

No one can predict whether or not this winter will be as brutally cold as 2013/14, but given how quickly supplies declined from record levels in November with average temperatures over the last 30 days only slightly below normal, it appears storage will continue to decline below the 5-year moving average unless temperatures are above average this winter.

But if we experience colder than normal weather, as most meteorologist are predicting, Natural Gas prices will likely increase as supplies are drawn down. As I am writing this report, Natural Gas is trading near $3.74 MMbtu, and if cold weather returns in January, we may test $4.00 MMbtu near-term. As you can see below, NOAA’s 8 to 14-day is forecasting below average temperatures for most of the United States in early January:

If this forecast is correct, Natural Gas prices will likely increase near-term. Therefore, if you have not already hedged your cost of Natural Gas or Electricity, it would be wise to do so. If you followed my reports since my March 7^th Energy Alert, you know I warned we are in the early stages of a Bull Market, and it was highly likely the average price of Natural Gas would be significantly higher over the following 12, 24 & 36 months.

Long-term, if temperatures moderate later in January, prices could pullback, but still likely maintain the pattern of higher highs and higher lows, which has been in place since the March 2016 low. But if temperatures remain colder than normal in January and February prices could move much higher.

It would be easy to fall into the trap of believing it is too late to hedge your cost of Natural Gas and Electricity with rates higher than earlier this year, hoping you can catch the next decline. But as I wrote in the Oct 6^th Energy Alert, another Bull Market characteristic supporting hedging your cost of Natural Gas and Electricity now is backwardation.

Backwardation occurs when nearby contracts sell at a higher price than contracts further out.

The chart below is example of a Bull Market in Natural Gas from 2002 to 2008, which was also a period of backwardation in the forward markets:

During the Bull Market from 2002 thru 2008, the Natural Gas and Electricity markets were consistently in backwardation and hedgers who hedged longer-term benefited by reserving lower rates further out in the forward markets.

Based on all the factors delineated in my reports since my March 7^th Energy Alert, I believe, we are in the early stages of a Bull Market, and hedgers taking advantage of backwardation in Natural Gas and Electricity, like 2002 to 2008, will benefit by reserving the lower rates presently offered in the forward markets.

Although nearby contract prices have increased since my Oct 6^th Energy Alert, as you can see below backwardation is still available in the forward markets:

Jan 2017 – $3.74 per MMbtu

Apr 2017 – $3.53 per MMbtu

Apr 2018 – $2.97 per MMbtu

Apr 2019 – $2.70 per MMbtu

Apr 2020 – $2.70 per MMbtu

Astute hedgers understand the wisdom of reserving rates in the forward markets when they are below nearby rates, especially when, over the last 20 years, the average rate was always higher the following 12, 24 & 36 months after trading near the lows we experienced in March 2016.

Therefore, if you have not already hedged your cost of Natural Gas and Electricity, I recommend you do so near present levels. As a hedger, your objective should not be to catch the exact bottom, but to reserve rates lower than the expected average rate over the term of the hedge.

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 now. I invite you to call one of our energy analysts to help you plan a hedging strategy appropriate for your situation.

Ray Franklin
Senior Commodity Analyst
727-400-3170