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Buying strategies - June 20, 2014

Buying strategies

Market Overview

Out of the frying pan and into the fire—or maybe out of the freezer. For energy buyers, spring likely seems too short, as the focus has quickly shifted to summer risks. And, while spot energy prices have been low, there has been no relief in long-term energy prices. The Polar Vortex will not be easily forgotten.

Since our April report, NYMEX futures have only moved modestly. The details are in the numbers below:

(all prices are in MMBtu) 6/19/2014 Change since 4/10/14
NYMEX Contract
Prompt Month (July 2014) $4.58 0.09
12-Month Strip $4.33 0.03
Cal '15 $4.29 0.07
Cal '16 $4.46 0.14
Cal '17 $4.32 0.18

But, here is a critical point regarding both natural gas basis and regional power prices. The NYMEX continues to lose importance in relation to prices of either commodity at a regional level—especially for the Midwest and Northeast. This article will not address basis trends at a granular level (please reach out to your Direct Energy Business representative for more information), but basis has been more volatile than the NYMEX. Prices for many eastern basis points reflect ongoing severe summer discounts due to shale and extreme winter premiums due to pipeline constraints. The breakdown of the correlation between electricity forwards and the NYMEX is largely attributed to the regional gas basis volatility, along with premiums due to regional generation concerns and Polar Vortex premiums.

Natural gas storage remains the key NYMEX driver going into the summer. Spring weather has been relatively mild for most of the country and, combined with strong production growth, the last six injections have exceeded 100 Bcf. And, a new record could be on the way. However, the deficit remains huge. Inventories are currently 706 Bcf (or 29%) behind last year and 851 Bcf (33%) below the 5-year average. So, thus far, the huge injections have not been enough to push prices significantly lower because of the huge deficit. At this point, storage is not expected to erase the deficit. End-of-October inventories could range from 3,200 to 3,500 Bcf, compared to last year’s 3,809 Bcf.

Beyond moderate temperatures, record gas production has contributed to strong injections. Thanks to shale gas, domestic dry natural gas production exceeded 68 Bcf per day during May. Coal and gas continue to compete in the generation stack and the economics of switching will impact the NYMEX and the basis, as well as storage results.

Market Outlook

So what does all of this mean going forward? Overall, the outlook has not changed significantly compared to two months ago.

Summer 2014 is a weather bet at this point for both natural gas and power prices. Thus far, huge injections have not pushed Prompt Month natural gas futures below $4.50. That is because the primary summer risk is July and August heat. But, if the heat does not show up, then the reward could be ongoing large injections, a severe shrinking of the deficit and a potential break in near-term prices. If it is hot, then the storage deficit will remain large and high prices will be needed to discourage demand. This is the weather bet for those that have not yet hedged. Thus far, there has not been widespread extreme heat and forecasts are calling for a milder than average summer for the east. But remember, these same experts did not predict the Polar Vortex.

Regarding power prices, June day-aheads are very low, but that does not mean that July will follow—unless the weather remains mild. Once specific opportunity may be last-minute ERCOT hedging, as summer prices have fallen dramatically in Texas over the last month.

Winter '14-'15 projections have changed even less than the summer. Prices will be primarily driven by storage levels and, once again, the weather wildcard. I’m going to focus on storage because weather is very difficult to predict before it’s too late to effectively manage risk. However, at minimum, this last 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, will likely not reach last year’s levels and the market has given up. An ongoing problem is the current NYMEX curve: Winter NYMEX pricing is only $0.08/MMBtu above summer prices. This does not cover the cost of storage in most cases. In the Northeast, regional and seasonal gas basis may improve the economics but not so in the Southwest production area, where the basis is more tightly correlated to the NYMEX. Storage owners are not incented to inject unless economics make it worthwhile. If storage injections would slow, then winter prices will need to rise in order to incent additional injections OR winter prices will rise because of the risk of lack of supply. So, winter prices may have more upside than summer when excluding the weather wildcard.

And to reiterate this point one more time, winter gas basis remains very strong and the disconnect between regional power prices and NYMEX prices is strongest in the pipeline-constrained Northeast.

Long-term prices have moved up somewhat over the last few months and that makes sense, as the bullish outlook for the long-term remains solidly in place. There are significant bullish factors that don’t appear to be going away:

  • EPA regulations and impacts on the coal-gas generation mix
  • Exports of LNG starting in 2016 and, just as importantly, pipeline exports to Mexico
  • Lower domestic natural gas prices (compared to international) have increased industrial demand
  • Long-term potential for gas demand for the transportation sector

There has been news from the EPA, but the price impact has been surprisingly negligible. Why? Because, except for the Mercury Air Toxics Standards (MATS), the other rules are less certain and longer-term. Here is a very brief summary:

  • Mercury Air Toxics Standards (MATS) are set to be implemented in 2015 and 2016. Impacts are known and significant (coal plant upgrades and retirements) and are already priced into the forward curve.

  • Cross State Air Pollution Rule (CSAPR) was big news in 2012, but was next effectively cancelled until the Supreme Court’s recent reversal and statement that the rule could be implemented. However, compliance with MATS will likely results in overall compliance with CSAPR. And, the exact details of the rules must be rewritten and timing is uncertain.

  • Cooling Water Intakes regulations were also announced by the EPA but were less restrictive than anticipated and again, no immediate impact is expected that would drive prices.

  • The Obama Administration announced carbon emission rules with great fanfare. However, the impacts are unknown, as states are not required to submit compliance plans until 2016 with implementation expected in 2018 or later.

What are the potential key bearish factors? 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 that 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. There has been a real local effect here in Pennsylvania. And, new pipeline infrastructure could increase gas basis in certain regions where excess supply is currently trapped, while reducing basis in markets that gain access to new supply.

Beyond shale, there are numerous wildcards that could strengthen or weaken prices. Be careful basing your strategy on any assumption that these factors will always drive prices in one direction.

Weather = Tough to predict.

Economic collapse = Tough to predict.

Market surprises = Tough to predict.

Strategy Considerations

Strategy concepts have not changed materially over the last two months, except that the lack of downside is confirmation that the market believes in the fundamental changes caused by the Polar Vortex. And, sustained higher prices since last November 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.

First, if you’re unhedged for the summer, it is a weather bet. Remember that bets can be won and lost and the oddsmakers in this case are the weather forecasters.

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 are dependent on weather, which is a huge point of risk itself. Consider locking in now to manage risk or make sure that risk is acceptable to your business because trying to time the market on a day-to-day basis is extremely difficult.

For 2015 and 2016, the considerations are different, depending on risk appetite. There is value (due to discounted prices) and there is risk (due to bullish fundamentals), but there is also time. However, for 2015, there's only about six months. If the numbers work for you, consider moving forward. Waiting may be effective if you’re able to stomach summer market volatility and recognize that the strategy may backfire if it is extremely hot. And, have a plan in case you’re wrong. The bullish nature of the storage deficit may limit downside opportunities.

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

This type of market plays well to managed products. Recently, volatility is a reason to buy, but price strength may be a reason not to hedge and fundamentals vary by region. So, consider a product that allows layers. Load Following Block & Index may be a fit for customers that want layering that results in 100% fixed. If you're looking for something that includes advisory services, reporting and transparency, you may want to consider PowerPortfolio.

First, since many managed products include participation in the index markets, be sure to learn from last winter. Risk of index market participation should be assessed—and this doesn’t only apply to winter in the Northeast. A hot summer could cause exposure and any region can experience price volatility. But last year’s volatility could also cause inappropriate risk premiums in forward prices, so don’t automatically write off the index market.

The flexibility of managed products allows more creative hedging strategies. For 2014, recognize the reality of 2014 strength by executing defensive hedges to cover any open positions within your plan but consider leaving some aggressive final hedges 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 before the Vortex and may not appear low even though they are discounted versus the near-term and may compare favorably to recent index price levels. There is time, so this really creates opportunities for gradual layering with time stops to take some risk off the table now. In most regions, 2015 and 2016 prices look best and there are still opportunities for future buys during dips for those timeframes. It's important to 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.