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Buying strategies - April 11, 2014

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Market Overview

Winter and the Polar Vortex are finally over so energy managers are hopeful that prices will fall. Let’s recap the winter before diving deeper into key considerations and the market outlook. Here are a few winter highlights:

  • The NYMEX Prompt Month closed at $6.149/MMBtu on February 19, a 5-year high.
  • The Polar Vortex caused record natural gas demand of more than 138 Bcf/day. The demand came from both heating load and electric generation, since traditional generation sources (coal and nuclear) were unable to meeting demand spikes.
  • Spot gas prices to New York City reached $50/MMBtu, with prolonged spikes over $20 from Chicago to New England.
  • Average spot power prices for some days surpassed $500 in PJM, over $300 in NYISO and NEPOOL, and over $200 in ERCOT.
  • Strong sustained gas demand caused huge withdrawals from storage, resulting in inventories reaching their lowest levels since 2003.
  • Domestic gas production remained robust (near 66 Bcf/day) thanks to shale, despite a few periods of well freeze-offs.

Prompt Month natural gas futures have fallen, as the winter months rolled off the board and volatility has significantly decreased. But overall, prices have remained strong and have even risen modestly over the last few weeks. Long-term prices have also risen, but remain significantly discounted compared to the near-term.

The details are in the numbers below:

(all prices are in MMBtu) 4/10/2014 Change since 12/31/13
NYMEX Contract
Prompt Month $4.65 0.55
12-Month Strip $4.69 0.5
Cal '15 $4.36 0.22
Cal '16 $4.22 0.1
Cal '17 $4.32 0.18

Natural Gas Storage

Natural gas storage activity has been a key driver of the market volatility of the last few months. The Polar Vortex caused the largest withdrawal on record (287 Bcf for the week ending January 10, 2014), five total withdrawals of more than 200 Bcf during January and February, and the largest March withdrawal on record (195 Bcf for the week ending March 10, 2014). The result is that current inventories as of April 4 are at 826 Bcf, which is 849 Bcf (50.7%) below last year and 997 Bcf (or 54.7%) below the 5-year average.

Market Outlook
So what does all of this mean going forward? Many buyers are hopeful for a spring dip—but remember that the market rallied last April. Has the view of the remainder of 2014 and the long-term changed just because the winter ended? Not really. In fact, many traders believe that there is significant support to market prices and the market may even be bullish.

They may or may not be right, and here's why...

Summer 2014 prices (May-October NYMEX = $4.68/MMBtu): are primarily supported by the storage deficit, which is huge. Natural gas injections would need to exceed normal injections by 4.7 Bcf/day to reach the 5-year average going into the winter—and this is above the expected rate of growth of shale gas production. High prices are the best incentive to increase injections via supply growth and demand destruction, which would occur through gas-to-coal switching in the generation stack. Of course summer weather is a huge wildcard, which means risk or reward, but this won’t be known until July or August and waiting is huge risk itself.

Winter 2014 prices (November14-March15 NYMEX = $4.80/MMBtu): will be primarily driven by storage levels and, once again, the weather wildcard. Weather is very difficult to predict before it’s too late to effectively manage risk however, at minimum, this past winter should be a reminder that winter weather risk is significant if you’re on a variable/index product.

Natural gas storage: As already noted, it is unlikely that storage will reach last year’s levels (~ 3,900 Bcf) unless we have an extremely mild summer AND shale production growth exceeds expectations (not by just growing, but by growing faster than expected). Some believe that 3,500 Bcf is a key threshold to reach to have sufficient storage for next winter. This would mean reducing the current deficit from 878 Bcf to 331 Bcf (which equates to 2.6 Bcf/day of incremental injections). This is possible, but definitely not a slam-dunk.

NYMEX: One problem is the current NYMEX curve. The winter NYMEX is only $0.12/MMBtu above the summer NYMEX. This does not cover the cost of storage in most cases. In the Northeast, regional and season gas basis may improve the economics, but that is not so in the Southwest production area where basis is much more closely correlated to the NYMEX. Storage owners are not incented to inject unless economics make it worthwhile. If storage injections start slow, then winter prices will need to rise in order to incent additional injections OR winter prices will rise because of risk of lack of supply. So, winter prices may have more upside than summer when excluding the weather wildcard.

Long-term prices (Cal 2015 = $4.32; Cal 2016 = $4.22): are significantly below prices for 2014, so that value alone makes are purchase worth considering. Plus, the market focus has been squarely on the near-term due to the volatility caused by the Polar Vortex. As the focus shifts, volatility may increase. And there are significant bullish factors that don’t appear to be going away, including:

  • EPA regulations and impacts on coal-gas generation mix
  • LNG exports starting in 2016 (with approvals on exports increasing and the Ukraine situation adding a geopolitical incentive, the likelihood of U.S. exports to Europe is increasing)
  • Lower domestic natural gas prices (compared to international) have increased industrial demand.

This covers the bullish factors but what is missing to ensure a balanced approach?

Shale: If shale growth exceeds expectations due to economics and/or efficiency, then the near-term storage situation can be helped AND long-term bullish factors can be offset. But remember, significant growth is already expected, so the growth must exceed expectations. Shale drilling break-evens have already had supportive price impacts. In 2012, they contributed to the market bounce off of long-term lows. And, drilling economics have shifted focus from dry gas to wet gas by drillers as gas-alone economics have not provided sufficient returns. We've seen a real local effect of that here in Pennsylvania.

Beyond shale: there are numerous wildcards that could weaken prices, all of which are difficult to predict:

  • Weather
  • Economic collapse
  • Market surprise
  • Regional issues that impact both gas basis and power forwards

Strategy Considerations

Sustained market strength has not been seen in a few years but the fundamentals driving the strength are real. This may lead to tough budget-busting buying decisions and year-over-year rate increases. As always, the key is be proactive, realistic and balance the needs of your business with the realities of the market.

Fixed Price Customers

The key question here is what type of term?

For those with contract terms ending during 2014, there is huge risk exposure. Significant dips appear to be less likely before the summer, which is a huge risk point itself. So, consider locking in now to manage risk or make sure that risk is acceptable to your business. Trying to time the market over the near-term while hoping for a large dip is like rolling the dice—it may work but would require luck.

For 2015, the considerations are different depending on the risk appetite of your business. There is value (due to discounted prices) and there is risk (due to bullish fundamentals), but there is also time. If the numbers work for you, consider moving forward. Waiting may be effective if you’re able to tolerate summer market volatility and if you recognize that the strategy may backfire if it is extremely hot. The idea here is to have a plan in case you’re wrong and remember that the bullish nature of the storage deficit may limit downside opportunities.

Managed-product Customer Considerations (i.e. PowerPortfolio, Heat Rate and Block & Index)

First, since many managed products include participation in the index markets, make sure you learned from last winter and reassess your risk tolerance for index market participation.This doesn’t just apply to Northeast customers during the winter—other regions are also exposed and volatility can occur during other seasons. In addition, consider that last year’s volatility could also cause inappropriate risk premiums in forward prices. so don’t automatically write off the index market.

Flexibility within managed products allows more creative hedging strategies. For 2014, recognize the reality of 2014 strength by executing defensive hedges to cover any open terms within your plan. Also consider leaving aggressive final hedges open while looking for a summer dip. Obviously, this is a simplistic approach that should be revised based on your business and risk appetite, so adjust accordingly.

The benefits of layering are most apparent when looking at the long-term. These prices have risen compared to six months ago and may not appear low, yet they are discounted versus the near-term and may compare favorably to recent index price levels. You have time, so this really creates opportunities for gradual layering with time stops to take some risk off the table now (2015 may be most obvious but even 2016 and 2017 are attractive in some markets) while leaving opportunity for future buys during market dips. And, remember not to fight over pennies when worrying about dollars—if prices work for your business, then move forward.

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

Posted: April 11, 2014