Winter Update

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

The goal of this report is to bring you up to date as we move into the winter heating season. In my most recent reports, I said the recent collapse in Natural Gas prices was an excellent opportunity to enter new hedges and extend hedges already in place. I pointed out the bearish factors discussed in my reports were already factored into the price of Natural Gas, and today’s low pricing would be short lived and usher in much higher pricing in the years to come.

In my Nov 19^th report, I said if we experience a warmer than normal winter Natural Gas could test the 15-year low near $1.76 per MMbtu, but if it did, it would not be a sustainable price, and lead to an explosive rally.

My Dec 10^th report contained the 12-month chart below, which showed what took place after my Nov 19^th report:

(Click here for a free rate analysis)

I said the very warm fall weather experienced from Nov 19^th thru Dec 10th along with forecasts for warm weather until Christmas in the Midwest and Northeast pushed rates back down toward $2.00 per MMbtu, and if rates broke below $2.00 per MMbtu and made a run toward the 15-year low near $1.76 per MMbtu, I would consider it a Christmas gift for traders and hedgers alike.

Below is an updated 6-month chart, which shows what took place after my Dec 10^th report:

The day after my Dec 10^th report, Natural Gas closed below $2.00 per MMbtu, and the following week prices collapsed into Friday, Dec 18^th reaching a low of $1.684 per MMbtu.

But as I wrote in my Nov 19^th report, if we test the 15-year low near $1.76 per MMbtu, it would not be a sustainable price, and followed by an explosive rally. Therefore, the rally from $1.684 to $2.386 per MMbtu was a very predictable response to prices being at an unsustainably low level. Natural Gas is traded on the NYMEX and as with all commodities is classified as a “Zero Sum Game”

A “Zero Sum Game” is defined as a game where the sum of the winnings and losses of the various players is always zero, the losses always are balanced by an equal gain. Every Natural Gas contract purchased must be balanced by an equal number of contracts sold. This is important to consider since Natural Gas contracts have a limited life with the nearby contract expiring 3 days prior to the end of each month.

Therefore, when Natural Gas is at a very low price near expiration of the nearby contract it can result in explosive rallies when traders holding sold contracts are forced to purchase contracts prior to expiration to close their position. The timing of the rally can be triggered by a news event such as cold weather is finally moving into the Midwest and Northeast, which is what likely triggered the 41.6% rally in Natural Gas from Dec 18^th to Dec 29^th. This is referred to as a short covering rally, and is an example of the explosive nature of short covering rallies.

The question is where are prices going from here? The answer should be explored both from a short-term and long-term perspective.

Short-Term Perspective:

1. The short covering rally since Dec 18^th was triggered by the forecast for cooler weather finally moving from the western U.S. into the Midwest and Northeast.

2. The rally since Dec 18^th was on very light volume, which indicates the rally was based primarily on short-covering, and not on new positions purchased to be held after expiration.

3. Historically light volume short-covering rallies are not sustained, and prices will likely pullback from present levels.

Therefore, if you did not open the gift of unsustainably low prices before Christmas, you may have another opportunity with an expected near-term pullback. But I don’t recommend waiting for a possible retest of the Dec 18^th low. As previously stated this was an unsustainably low price and we may not return to that price level. But even if we do and you purchase a bit early, hedging near present levels will be effective from a longer-term perspective. The goal of hedging is to secure a rate lower than the average expected long-term rate, it is not catching the exact bottom.

(Click here for a free rate analysis)

Long-Term Perspective:

In previous reports, I emphasized if Natural Gas traded below $2.00 per MMbtu, it would be an unsustainable price leading to higher prices for years to come. This is caused by the effect low prices have on supply and demand. Below I discuss the effect low prices have on the supply and demand of Natural Gas.

Supply Factors:

1. Low prices are a disincentive for producers investing in drilling new rigs and motivates them to shut down unprofitable rigs until pricing increases. Although production is expected to grow year over year due to increased efficiency of rigs in the Marcellus and Utica regions, the rate of increase is slowing, and expected to continue to slow down due to the effect of low prices.

2. The production boom triggered by new fracking technology was primarily financed by debt. The FED’s policy of low interest rates motivated drilling companies to take on a large amount of debt based on their belief increased production would result in increased revenue and profits. The problem is although production increased revenue decreased due to prices being so low. Many drilling companies are now at risk of declaring bankruptcy. This is not only limited to smaller drillers, the stock of Chesapeake Energy, the second largest Natural Gas producer in the United States, is down over 75% YTD, and many investors are questioning the long-term viability of this previously highly respected icon of the energy industry. The closure of a large number of drilling companies will have an adverse effect on production.

3. The low price of Crude Oil is also resulting in a large decrease in rigs drilling for oil. In the period ending December 23, the number of rigs drilling for oil in the United States totaled 538, compared to 1,499 a year ago. This is important to note because residual Natural Gas is a byproduct of Oil Rigs and the 64% decrease in Oil Rigs over the last year will have an adverse effect on the production of residual Natural Gas.
   

Demand Factors:

1. Over the last 2 years many Coal fired power plants closed due to increased EPA rules regulating air pollution, and more are scheduled to close over the next year. The major beneficiary was Natural Gas. The EIA’s Short-Term Energy Outlook released on December 8^th estimated the amount of Natural Gas used to generate Electricity increased approximately 18% in 2015, going from 3,087 billion kWh per day in 2014 to 3,655 billion kWh per day in 2015.

2. Liquefied Natural Gas (LNG) Exports are scheduled to start early in 2016 from Cheniere’s Sabin Pass export facility. Although it is too early to estimate how much LNG will be exported, it is safe to assume with over $20 billion dollars invested to build this facility they are highly motivated to export as much LNG as possible to pay off debt created by the project. We will give you further updates on the exports from this facility when actual data becomes available.

3. Increased exports of Natural Gas to Mexico. Pipelines to export Natural Gas to Mexico has nearly tripled since The EIA reported Mexico’s demand for U.S. Natural Gas increased approximately 50% over the last year. This growth is expected to continue with Mexico committed to expanding their electricity sector.

Obviously, one factor we cannot forecast from a long-term perspective is the effect of weather. But weather factors do effect demand short-term. Until recently, demand was adversely effected by the very mild weather experienced the previous 2 months, but as recently observed this can abruptly change. The take away is long-term hedging decisions should focus on the effect pricing inherently has on long-term supply/demand factors, and not on short-term weather forecasts.

When prices are too high from an historical perspective, long-term supply/demand factors pull prices lower, and when prices are too low from an historical perspective, long-term supply/demand factors support higher prices. In my Nov 19^th report I said even if we experience a warmer than normal winter, prices would likely still rise from present levels for no other reason than prices are just too low!

An excellent example is what took place in Natural Gas in 2012. It rallied off its spring 2012 low even though the fundamentals were terrible. Why? Prices were just too cheap! The winter of 2011/12 was the warmest in 100 years; therefore, storage levels at end of the winter were the highest in history. In addition, due to new fracking technology production increased by the largest amount year over year in history.

Logically you would have thought ending the winter with the highest storage level in history for that time of the year, and experiencing the largest increase in production in history over the next 12-months should have resulted in lower prices. But as you can see in the 20-year chart of Natural Gas below prices increased dramatically.

(Click here for a free rate analysis)

After briefly trading below $2 per MMbtu early in 2012, Natural Gas rallied above $4 per MMbtu by the end of the winter of 2012/13. This took place with record production and a milder than normal Winter in 2012/13. Why? The only possible explanation was pricing was simply too low, and long-term hedgers knew supply/demand factors would support higher prices.

No one knows whether the final low for Natural Gas in this down cycle was reached on Dec 18^th. It is possible if temperatures are much warmer than normal from Jan thru Mar, prices could go lower for a brief time. But I emphasize for a brief time and would be followed by an explosive rally. If you look closely at the above chart, whenever Natural Gas declines below $2 per MMbtu prices are always much higher on average over the next 12, 24 and 36 months.

Past performance does not guarantee future results, but if you do not learn from history, you are doomed to make the same mistakes in the future.

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