Ramifications of Low Natural Gas Storage Levels

The purpose of this Energy Alert is threefold:

1. Discuss performance of Natural Gas and Electricity rates since my Jan 30th Energy Alert. I refer to the price action of Natural Gas and Electricity together because of their high price correlation.
2. Short-Term – Market Perspective
3. Long-Term – Market Perspective

1) Performance of Natural Gas and Electricity since my Jan 30th Energy Alert.

In my Jan 3rd and Jan 30th Energy Alerts I warned we were entering the winter heating season with relatively low natural gas inventory levels and the very cold winter we were experiencing would draw down supplies to critically low levels. I stated if temperatures were normal in the high usage areas in Feb and Mar, Natural Gas prices would likely trend higher and marginally exceed the $6.00 price objective I projected in my Video Alerts, but If temperatures were colder than normal, a significant Natural Gas storage crisis could develop this winter and Natural Gas and Electricity rates could skyrocket and Natural Gas would trading higher than my original $6.00 price objective.

I am sure you are aware temperatures in February have been colder than normal in the eastern 2/3rds of the nation and natural gas storage levels continue to plunge. In its last storage report released on Jan 20th, the EIA announced inventories of Natural Gas now stand at 1.443 trillion cubic feet, which is 40.3% below last year and 33.9% below the five-year average.

Natural Gas prices surged in response to the tightening supplies with the nearby contract of Natural Gas reaching high of $6.49 per MMBtu on Monday before pulling back sharply to the 50-day Moving Average into today’s expiration of the nearby contract.

The chart below shows the trade action of the nearby contract of Natural Gas:

The above chart reflects the high volatility I predicted and I believe is a microcosm of what is coming.

2) Short-Term – Market Perspective.

The decline of the nearby contract of Natural Gas to the 50-day Moving Average is not surprising in light of the size of its rally over the last month. Natural Gas is a commodity and commodity markets are a zero sum game, which means purchased positions must be sold prior to expiration to take profits and avoid delivery of the product. Over the last 3 days the nearby contract plunged while all other contracts thru Nov 2014 declined to near $4.50 MMbtu, which is the 2013 spring breakout area I discussed last month.

Also, the decline this week served the dual purpose of allowing large hedgers who profited from the rally in Natural Gas to switch from the nearby contract to the next contract months at lower price levels prior to the anticipated next leg up.

Below is a graph of the new nearby contract of Natural Gas:

Note: I have drawn 4 points in the above chart. Major market moves often follow a 5 wave pattern. Point 1 shows the completion of a wave 1 advance. Point 2 shows the completion of a wave 2 correction. Point 3 shows the wave 3 advance completed on Monday. Point 4 shows where Natural Gas is trading today. I believe when Natural Gas completes its wave 4 correction it will experience a wave 5 rally to new highs. Tomorrow the EIA is expected to announce a draw in supplies of approximately 110 billion cubic feet leaving inventories at approximately 1.333 trillion cubic feet with 5 more storage reports due prior to the end of the winter heating season.

As I am writing this report another mini Polar Vortex is blanketing the high usage areas and next week’s storage report is expected to show another large draw and storage levels in all likelihood will end the winter season well below 1 trillion cubic feet. In my Jan 30th Energy Alert I stated the last time Natural Gas storage levels declined below 1 trillion cubic feet was in 2003, and Natural Gas rallied from $5.00 to almost $12.00 within 2 months.

I don’t believe Natural Gas will rally to $12.00 over the next 2 months, but I believe a rally in the nearby contract to $7.00 is very possible, and the net effect on electricity rates would be significant. Therefore, if you have not already hedged Natural Gas and Electricity or have hedges expiring later this year, I recommend you take advantage of this wave 4 correction.

3) Long-Term – Market Perspective.

There appears to be a consensus when this brutal winter finally draws to a close; rates will collapse to pre-winter levels. Although I agree Natural Gas will likely experience a correction in the spring I do not agree it will collapse to early 2013 levels. If as anticipated Natural Gas Storage levels end the winter heating season well below 1 trillion cubic feet producers will need to increase production at least 3 billion cubic feet a day over last year to replenish inventory levels in time for next winter’s heating season. The net effect will be increased demand for Natural Gas as producers scramble to increase production in addition to the normal demand of end users.

Therefore, we know demand for Natural Gas will be much higher in 2014 than it was in 2013 just based on the need to replenish low storage levels, but there is another factor we must consider. The summer of 2013 was relatively 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 meteorologist, the winter rally we are experiencing could be dwarfed by a rally this summer.

One last point concerning the shape of the Natural Gas and Electricity curves at this time. Natural gas and in most regions Electricity are experiencing backwardation. By definition backwardation occurs when nearby contracts are selling at a higher price than contracts further out. Many traders mistakenly believe this is a bearish configuration, but as I have repeatedly mentioned over the last year I believed we are in the early stages of a bull market similar to 2002 to 2008. During this period Natural Gas and Electricity markets were consistently in backwardation and hedgers who hedged longer-term benefited by the lower rates further out in the pricing matrix.

The bottom line is, I believe due to many factors influencing supply and demand in the coming years we are entering a period of high volatility similar to 2002 to 2008. If you presently have a variable rate or a fixed rate hedge expiring later this year I recommend you contact one of our energy consultants to help you properly time your next 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 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