Warm Summer Forecast Increases Risk for Higher Prices!

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

In my March 7^th report, I pointed out 2 conditions were present, which are characteristics of a major bottom. Unsustainably low prices and a high level of negative news. Unsustainably low prices influence suppliers to decrease production, which leads to higher prices, and a high level of negative news is already factored into low prices and rates are primed to move higher!

I based this observation on the empirical evidence contained in the 20-year chart of Natural Gas below:

When prices decline below $2.00 per MMBtu, rates were always higher on average the following 12, 24 & 36 months. Past performance does not guarantee future results, but if you don’t learn from history, you are doomed to make the same mistake in the future.

As you can see in the chart below since writing my March 7^th Energy Alert, Natural Gas has rallied more than 25%:

The rally since my March 7^th Energy Alert was sustained with no major corrections. As I explained in my April 4^th Energy Alert, we may have weakness at times, but the conditions supporting a major bottom are in place, and the upside risk of higher prices for unhedged accounts far exceeds the potential downside reward of waiting for a lower entry point.

The question is with Natural Gas prices still at very low historical levels is there a potential risk factor on the horizon that could support much higher prices?

To answer this question, you must understand that the price of Natural Gas is based on many supply/demand factors, but the greatest intermediate factor is the weather. The mild winter we just experienced was the single greatest factor leading to prices trading near a 20-year low on March 4^th. The very cold winter in 2013/14 was the single greatest factor leading to prices 3 times as high as the present price near $2.00 per MMbtu.

The chart below will help you appreciate how Natural Gas reacts to weather extremes:

As you can see in the above chart, during the very cold winter of 2013/14, we were introduced to the weather phenomina called “Polar Vortex”, and Natural Gas rallied to a high of $6.493 per MMbtu in Feb 2014. While this year the mild winter of 2015/16 was the major contributing factor leading Natural Gas prices to reach a low of $1.611 per MMbtu in March 2016.

Natural Gas is one of the most volatile markets traded on the NYMEX, and volatility is a major risk for any market. Hedgers by definition should be risk adverse; therefore, since weather extremes are the greatest factor leading to extemes in prices, hedgers should always be aware of potential weather extremes setting up in the future.

Therefore, with Natural Gas trading at a very low historical price, are there any potential weather extremes hedgers should be aware of at this time?

The answer is yes, and I am writing this report to inform you we may experience a warmer than normal summer this year, which would likely support higher Natural Gas prices.

The “Weather Channel” today released a report forecasting temperatures May thru August will be warmer than average across a large part of the western and northern United States.

In his report, Dr. Crawford, chief meteorologist at “The Weather Channel” said the effects would be greatest from June thru August:

Dr. Crawford said, “The historically strong El Nino event is weakening rapidly and we should transition to La Nina conditions by summer and this favors a hot summer, especially across the northern U.S.

Dr. Crawford warns another factor regarding temperatures this summer are sea surface temperatures in the western North Atlantic, which are forecast to be warmer than we have seen over the past five years. That often results in warmer temperatures in the eastern U.S.  In addition, conditions across the Pacific Ocean, influenced by the strong El Nino, will favor warmer-than-average temperatures across much of the West, especially the Pacific Northwest.

Most computer forecast models continue to suggest that the transition from El Nino to La Nina conditions will occur this summer. Typically, La Nina summers feature hotter temperatures from the central U.S. into the Northeast, with the hottest month being July. 

Dr. Crawford is not alone in forecasting the potential for a transition from El Nino to La Nina conditions with NOAA issuing a La Nina watch on April 14^th. NOAA’s next major update will be released on May 12^th, and we will give you an update of this report after it is released. Although no one can predict with certainty when La Nina conditions will be in place and how extreme it’s effect will be on weather in the U.S., it is certainly a risk factor hedgers need to be aware of, especially given Natural Gas is at a very low historical price.

Therefore, if you have not already hedged your cost of Natural Gas and Electricity, I recommend doing so at this time. Although, short-term forecasts suggest milder than normal weather could lead to lower prices near-term, I do not recommend delaying hedging hoping for what historically would be slightly lower prices. Remember as I said earlier, the upside risk of higher prices for unhedged accounts far exceeds the potential downside reward of waiting for a lower entry point.

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 Commodity Analyst
727-400-3170