Energy Alert: Short-Term Pullback a Buying Opportunity?

(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 discuss Natural Gas’s pullback since Apr 5^th, and why from a cyclical perspective, the near-term decline should be considered a buying opportunity, and longer-term hedges are prudent for those who are risk averse.

1. Short-term Pullback a Buying Opportunity?: In my March 27^th Energy Alert, I stated, from a cyclical perspective, Natural Gas and Electricity prices will likely increase long-term, and short-term pullbacks should be considered buying opportunities. From a cyclical perspective, after reaching the spring 2016 low, Natural Gas has formed a similar pattern to the spring 2012 low, and the final highs in the present cycle will likely be attained due to a weather event such as a warmer than normal summer, colder than normal winter, or a geo-political event, and corrections in the cycle will occur periodically due to mild weather conditions.

The chart below shows Natural Gas from a cyclical perspective:

As shown by the green lines in the above chart, after reaching seasonal lows in 2013 and most recently in 2017, Natural Gas traded higher, and the red lines show a pullback in 2013 and the recent pullback in 2017.

In 2013, after completing its pullback, Natural Gas prices exploded as shown by the 2^nd green line due to a colder than normal winter in 2013/14. Obviously, there is no guarantee history will repeat itself this year, but based on the above charts, the risk of an explosive rally is clearly possible. The rally could be triggered by a warmer than normal summer, colder than normal winter, or continuation of the structural imbalances, which I discussed detail in my February 9^th Energy Alert.

The recent decline in prices since April 5^th was primarily due to 2 factors:

1. Mild weather decreased demand in April, which is turning out be one of the mildest Aprils since 1950, continuing the pattern of extremely mild weather over the last 6-months. Demand can be estimated by using Heating Degree Days (HDD), which I discussed in my February 9^th Energy Alert, and HDDs have been well below the long-term average and even lower than the very mild 2015/2016 winter.

2. Mexico gas exports from the United States averaged below 3.0 Bcf/d in April down from over 4.0 Bcf/d due to pipeline maintenance. The decrease in Mexico gas exports is normal and temporary, but the decreased Mexico exports along with mild weather considerably reduced the structural deficit in April.

Based on the 2 above factors, I am not surprised Natural Gas prices declined in April, and I am not surprised as you can see in the chart below the decrease in prices has been relatively small:

The market is forward looking and understands when Mexican exports ramp back up, and our weather returns to normal levels, Natural Gas’s demand will increase and prices are primed to move higher, which is why I believe the near-term decline is a buying opportunity, and hedging now is prudent for those who are risk averse.  It is certainly possible near-term rates can decline further, but longer-term the downside reward potential is minimal versus the upside risk.

Longer-Term Hedges Prudent for Those Who are Risk Averse: In my October 6th Energy Alert, I explained long-term traders were aware of a market phenomenon called backwardation, and Natural Gas and in most regions Electricity were in backwardation. Backwardation occurs when nearby contracts are sold at a higher price than contracts further out. Some traders mistakenly believe this is a bearish configuration, but large hedgers understand historically this is a bullish pattern.

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, Natural Gas and Electricity markets were consistently in backwardation and hedgers who hedged longer-term benefited by reserving the lower rates further out in the forward markets.

Based on all of the factors I have delineated in reports since my March 7^th, 2016

Energy Alert, I believe, we are in 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.

 Below are examples of the present backwardation in Natural Gas’s April Contracts.

•   Present – $3.25 per MMbtu
• Apr 2018 – $2.98 per MMbtu
• Apr 2019 – $2.77 per MMbtu
• Apr 2020 – $2.75 per MMbtu

The price of Natural Gas is lower in the forward markets, and astute hedgers understand based on experience, they will benefit by reserving rates longer-term in the forward markets when they are below nearby rates.

Conclusions

The recent pullback should be considered a buying opportunity and backwardation favors hedging longer-term verses shorter-term.  

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

Senior Commodity Analyst

727-400-3170