Record Breaking Decrease in Supplies May Increase Risk of Higher Prices

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

In today’s report, I explain why Natural Gas’s apparently irrational decline is rational from a large hedger’s perspective. I have learned over the years hedging patterns don’t always make sense on the surface, but they make sense to those who understand 2 facts:

1. Long-term commodity markets always reflect supply/demand fundamentals. (Over the last 4 days, weather models have changed and are now forecasting cooler weather into late December, which increased the estimated draw of supplies by 80 Bcf.) Normally this news would have triggered a sharp rally, but instead Natural Gas continued to decline. Why? The answer is found in the second fact below.
   
2. Over the short-term commodity markets often trade counter to supply/demand fundamentals, which allows large hedges to ‘build’ long-term positions for the move that inevitably follows based on long-termsupply/demand fundamentals.

In my Nov 27^th Energy Alert, I said, as shown in the chart below, the risk versus reward ratio favors hedging the cost of Natural Gas and Electricity near present price levels:

But as you can see in the chart below, after my Nov 27^th Energy Alert, Natural Gas initially rallied to $3.20 per MMbtu prior to declining to $2.656 per MMbtu today, and could make a new yearly low near $2.50 per MMbtu:

This year’s low was attained on Feb 22^nd at $2.522 per MMbtu, and we could make a slightly lower yearly low near $2.50 per MMbtu. The question is why would this happen?

But before explaining why, I want to make it clear, I don’t recommend delaying hedging Natural Gas or Electricity hoping Natural Gas completes the pattern I am discussing. Natural Gas’s greatest risk is still higher prices, and from a long-term perspective, there is little difference in hedging at $2.90, $2.70 or $2.50per MMbtu. The purpose of this report is to explain why Natural Gas declined over the last 2 weeks, and why the recent decline is consistent to what often takes place prior to explosive rallies.

Hedging Patterns take time to develop and near completion, markets often trade counter to the prevailing opinion of where they are heading long term. As I write this report, Natural Gas supplies are 1% below the 5-year moving average, and cooler weather forecasted in December is expected to bring supplies 5% below the 5-year moving average by the end of the month. The continued tightening of supplies, due to structural imbalances, which I discuss in numerous reports starting with my Feb 9^th Energy Alert, support why I believe the fundamentals are pointing to higher prices.

But the apparent irrational recent decline in Natural Gas in face of tightening supplies is rational from a large hedgers perspective. What is the rational? Large hedgers have the wherewithal (Capital) to crush small speculators, so they can position themselves at the lowest price possible prior to what they believe will be much higher prices in 2018.

The perfect scenario would have Natural Gas’s counter intuitive low reached just below previous key support, which in this case would be the $2.522 per MMbtu low reached on Feb 22^nd, thereby triggering sell stops of speculators, and allow large speculators to complete building their last positions at the lowest possible price.

Conclusions:

The recent price declines of Natural Gas are consistent to what often takes place prior to explosive rallies. Obviously, there is no guarantee we will experience the perfect scenario of Natural Gas’s counter intuitive low being reached just below previous key support, but it is certainly possible, and as a speculative trader, I would be an aggressive buyer near $2.50 per MMbtu. But as for hedgers, who should be risk averse, the risk versus reward ratio continues to favor hedging the cost of Natural Gas and Electricity near present price levels, which from a long-term perspective are only slightly above key support at $2.522 per MMbtu.

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
North American Energy Advisory