Buying Strategies for a Volatile Market
Compiled Jan. 6, 2009
Market Overview
The pricing trends in the energy markets continued downward for most of December until a modest end-of-month rally that continued into the first week of 2009. Weakness in the economy remains the dominant factor influencing the current market as expectations of reduced energy consumption due to cutbacks by businesses and consumers have continued to apply downward pressure on prices.
In the energy sector, after falling by 20 percent during November, oil prices fell another 18 percent in December (from $54.43 on Dec. 1 to $44.60 on Dec. 31) and were even below $40 per barrel for the first time since 2003. In addition, natural gas fell again this month at a moderate pace. February natural gas futures declined from $6.60 on Dec. 1 to $5.85 on Dec. 31—a decline of 11 percent—and hit a 3 ½-year low of $5.24 on Dec. 22.
Several factors have contributed to the market’s rebound of up to 20 percent above December lows, including colder weather forecasts, interruption of European natural gas supplies by Russia, OPEC production cuts and Israel’s invasion of the Gaza Strip. Despite this rally, prices remain far below levels from a few months ago.
Despite colder weather, natural gas supply remains very strong due to a weak economy. Domestic supplies are up by 4 percent compared to a year ago, even with hurricane losses. There are early signs of reduced drilling activity as Rig Counts are down from September 2008 highs due to lower prices and credit constraints on natural gas producers.
Natural gas storage remains slightly below last year’s levels as stronger-than-normal early winter heating demand has somewhat offset strong supply and weak demand. However, it is possible that a surplus could occur in January for the first time since December 2007. Weather forecasts for the remainder of the winter are mixed, but any sustained, above-normal temperatures could result in an eventual storage glut during the summer or fall of 2009.
Electricity has followed the same trend as natural gas with very attractive prices for almost all terms and markets, in additional to current low index prices. Prices through 2009 are lowest, with 2010 and 2011 maintaining a premium due to the expectation that the economy will eventually recover or that there could be a negative supply response to sustained low prices. Nonetheless, prices for the long-term have declined dramatically during recent months.
Outlook
The primary price drivers remain the same. The current fundamentals of supply and demand remain bearish for the electricity sector as long as the economy remains weak and natural gas supply remains strong—and a change does not appear to be imminent in either case.
Recent market strength is a reminder of the various factors that can turn the market around quickly. But, it is difficult to tell whether we have seen the bottom or whether the recent bounce is temporary and the market will drop again. As noted above, a negative supply response is a risk factor to the downward trend. Sustained price declines, as well as the credit crunch, could reduce supplier incentives and capabilities to continue ongoing drilling programs that are adding supply to the market.
Day-ahead prices are extremely low for most regions and warrant consideration, but they are not without risks. The primary near-term risk factor is winter weather, which has been cold and thus supportive so far. A long, cold winter of sustained, below-normal temperatures does present significant upside price risks.
When building energy strategies, it is important to be cognizant of the possibility of market surprises and remember to learn lessons from the huge price volatility that occurred during 2008.
Fixed Price Customer Recommendations
Our recommendation is largely the same as last month, despite recent price strength.
- Fixed prices remain attractive and could be worth locking in; it is just a matter of term.
- Prices for 2009 continue to present a tremendous opportunity to fix power prices and lock in significant year-on-year cost reductions. At minimum, lock in through August to cover both the risky winter and summer peaks.
- For 2010 and beyond, the decision is not as easy since prices are at a premium relative to 2009. But, considering the more bullish outlook and the potential to fix long-term prices at the lowest levels available in several years, all customers should at least consider this option. If you do choose to wait, be sure to set a realistic strike price.
Portfolio Customer Recommendations
Similar to the Fixed Price Customer Recommendation, an appropriate strategy would be to take advantage of the huge market declines and lock up significant hedges for the closest 6-12 months. Remember that a layering strategy is not focused on picking the bottom, but rather trying to lock in value while managing risk.
- For 2009, even the most aggressive energy buyers should consider high hedge levels for winter and summer months to mitigate weather risk and to take advantage of severe price declines.
- For the shoulder months of spring and fall, lower hedge levels allow additional hedges if the recent rally is erased and/or to allow participation in dailies. But, keep in mind that the current forwards are below historical dailies in most regions and will provide year-on-year savings.
- Longer-term strategy depends on year-on-year price comparisons and customer goals and targets, in addition to market considerations. The more balanced outlook and the overall unpredictability of energy prices support early hedging at current low prices. Initial purchases make sense as a way to lock in low prices and reduce exposure to price volatility, but still allow participation in further downside.
- If purchases are deferred, consider time stops based on the likelihood that the economy will eventually recover, leading to a rally in commodity prices.
As always, consider your budget and/or year-on-year comparison and consult with your Portfolio Strategist regarding the appropriate strategy for you.
Submit your comments about this article.
All comments will be reviewed by Direct Energy Business and may not be deemed appropriate for this web site. You will receive a confirmation email indicating if your comment was approved or denied. We require a valid email address, but please note that your email address will not be published on this site. We are committed to protecting your privacy.
