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Buying strategies - December 6, 2013

Buying strategies

Market Overview

Volatility and weather have been the key market drivers over the last month but that should not be a surprise since November is a winter month and weather is the key driver of short-term natural gas prices.  We saw a mild start to November that drove forwards down and most natural gas contracts hit their all-time lows—even besting prices that were available during early 2012.  However, this dip was as short-lived as the mild weather.  November quickly turned cold and natural gas futures rallied.  Prompt Month futures rose by almost 50 cents to 6-month highs before stalling near $4.00, their key resistance level.  And, prices broke through that threshold yesterday, thanks to a bullish storage report.  Longer-term prices also rose but more slowly, as the rally was driven by short-term weather and the spread between the near- and long-term narrowed significantly.
(all prices are in MMBtu) 12/6/2013 Change since 10/24/13
NYMEX Contract
Prompt Month $4.11 +0.29 cents, all-time low of $3.52 on 11/4/13
Cal '14 $4.10 +0.23 cents, all-time low of $3.60 on 11/4/13
Cal '15 $4.16 -+0.11cents, all-time low of $3.83 on 11/4/13
Cal '16 $4.21 +0.05 cents, all-time low of $3.98 on 11/4/13

Market Fundamentals
Natural Gas Storage
As we head into winter, gas storage inventories will be more important than ever as an indicator of the balance of supply and demand and they continue to be a primary driver of short-term prices. The last injection of the season occurred in the week ending November 8 and inventories peaked at 3,834 Bcf, compared to last year’s all-time record of 3,929 Bcf.  From a storage perspective, winter begins in November and operators begin withdrawing natural gas to meet heating demand.  The withdrawal for the week ending November 29 was huge at 162 Bcf (compared to only 62 Bcf for the same week last year)—a number that was only exceeded three times all of last winter.  As of November 29, total U.S. inventories were 3,614 Bcf, which is 200 Bcf or 5.2% below last year and 104 Bcf or 2.8% below the 5-year average.

Supply & Demand 
While we don’t see any slowdown in the growth of shale production, which will limit upside in natural gas prices in 2014 and 2015, there are bullish factors on the way.

  • Exports to Mexico to feed growing gas demand have already doubled to over 2 Bcf per day .  While not as sexy as liquefied natural gas (LNG), it is much simpler (logistically and financially) to expand a pipeline into Mexico than it is to construct an LNG export terminal to reach Asia or Europe.
  • Industrial demand is also growing gradually, due in some part to a strengthening U.S. economy but primarily due to the advantage of cheaper energy costs in the U.S.  However, large demand increases require significant plant expansions and large capital outlays, which do not happen overnight.
  • The growing share of natural gas in the generation stack is another source of demand growth.  Although gas generation is down since 2012, this is mostly due to higher prices, compared to 2012 lows.  This demand will return quickly however if natural gas prices fall.  And, there will be more permanent coal-to-gas switching, as the EPA’s mercury rules take effect beginning in 2015, which will necessitate the closure of certain "dirty" coal plants that are critical to the grid. 
  • Exports via LNG are still expected to commence eventually, but not until 2016 or later.  Exports of 6 Bcf per day are projected by 2018. 

Market Outlook
There are very different stories for the near-term and long-term as we enter winter.  The near-term outlook depends on weather and storage, which is driven by weather.  November finished cold and the current forecast is calling for extreme cold for most of the lower 48 states during the first half of December.  This will result in strong heating demand and large storage draws. The result has already been 7-month highs for prices.  But more cold will be required to sustain high prices—or the benefits of prolific shale growth will drive prices lower.  And, growth in the storage deficit could delay a drop in prices driven by any warmer weather, as a storage deficit is one way to absorb excess supply.

Beyond the winter, the market’s range is expected to be somewhat rangebound.  Upside will be limited by ongoing shale growth, while downside is limited first by any sizeable storage deficit and second by coal-to-gas switching.  Outside of short-term volatility, a gas floor is likely to be closer to $3.00 rather than the $2.00 lows of 2012 due to coal-to-gas switching economics. 

Finally, over time, the range should gradually increase due to the bullish factors noted above (exports, EPA regulations and LNG) that will somewhat offsest ongoing shale growth.  We see this change occurring in 2015 and especially 2016.

Strategy Considerations

If you’re short for any part of this winter, recognize that it is now a weather bet.   Paying high winter prices this late may allow you to sleep better at night but it will either result in paying a high price to avoid a higher price or paying a high price that includes a premium that may or may not actualize, especially if weather turns mild.

For customers on managed products with layering capabilities, it may be okay to execute short-term layers—even at high prices—just to mitigate some risk.  More importantly, recent price strength, especially for New England, should help you to develop a better long-term strategy.

If your business is focused on long-term strategies, your approach can be different but it will still depend on the type of product you have and your risk philosophy.  If you consider bullish long-term fundamentals, the range-bound nature of the market and the fact that prices are near the bottom of the range, could indicate a buying opportunity.   As noted above, winter dips are worth watching if they occur.  This is especially true if you're on a product with layering capabilities because you may already be looking at prices for 2015 and even 2016, depending on your company’s buying procedures and goals.  At the same time, any test of the upside of the price range is less of a concern, as long as the range is expected to hold.

Buying in the midst of a rally is generally not a good idea, although prices for some regions and terms remain low, so examine prices carefully.  But overall, it is best to ride out weather driven rallies.  And watch for the occasional winter dip that often occurs after the holidays, if weather moderates and storage is sufficient. 

In order to be ready to take advantage of dips, you must have a plan to move forward: 

  • Set targets while prices are high, which is the best time for analysis, discussion and obtaining the necessary internal approvals.  Then, when/if prices fall, you can move quickly and take advantage of dips—even if they are brief.
  • Remember that budgets that require year-over-year rate declines may be unrealistic (depending on the timing of your previous contract) and can result in undue risk if you are setting targets that are unlikely to occur.
  • Take advantage of any flexibility that your contract provides—in particular, layering and index market participation—but remember to base your strategy on analysis rather than emotion.  And, remember that trends change, so don’t assume that the best strategy for last year is the best going forward. 
  • Long-term prices may still present a good value, as they have risen much slower than the near-term.  And, the flat forward curve provides opportunity for stable prices.
  • Although not covered in this article, consider regional fundamentals—not just the NYMEX.
  • Plan now for 2015.  Remember, the best time to buy 2013 was early 2012.

As always, consider your budget and/or year-on-year comparison and consult with your Portfolio Strategist regarding the appropriate strategy for you.