Buying Strategies
Compiled August 16, 2010
Market Overview
The U.S. is experiencing the hottest summer on record but as a testament to the bear market, forward prices have fallen. Since early July, the September 2010 NYMEX Henry Hub contract has mostly traded in a range of $4.25 to $4.75/MMBtu. The contract reached a high of $4.923 on July 30 before quickly retreating to its range.
Over the past week, the market has tested its recent lows, as the hot weather has been unable to support a bull market. Also, the mild hurricane season thus far has kept a lid on prices, although the peak of the season is still a month away. The market closed on August 16 at $4.228—the lowest settle since May 26.
Despite the relatively quiet forward market, the Eastern short-term markets have been higher than any point since 2008. The month-to-date average for on-peak prices in New York City (Zone J) has been over $89/MWh. Prices in PJM and NEPOOL have been similarly high, as the heat spikes have strained the power grids. July day-ahead prices were the highest since the summer of 2008. ERCOT has also seen high temperatures but short-term prices have remained relatively low since ERCOT generally has more available capacity than the Eastern markets. In California, the summer has been very mild and prices have been low there as well.
The National Oceanic and Atmospheric Administration (NOAA), although still calling for a very active season, has lowered its overall estimate for the hurricane season. The revised forecast is: 14-20 tropical storms, 8-12 hurricanes and 4-6 major hurricanes. To put this into perspective, the 30-year normal is 10 tropical storms, six hurricanes and three major hurricanes. In 2009 we saw nine tropical storms, three hurricanes and two major hurricanes. A key driver of these forecasts is the development of La Niña, or below-normal Pacific sea surface temperatures, which can dramatically impact global weather. Conversely, sea surface temperatures in the Atlantic Ocean and the Gulf of Mexico are higher-than-normal, which typically leads to an active hurricane season.
The hot summer has had an effect on the pace of storage injections and the total storage has fallen behind last year’s record pace. As of August 6, storage stood at 2.985 tcf, while last year at this time storage was at 3.143 tcf. The 5-year average is 2.766 tcf. Total U.S. storage capacity however has increased this year and is roughly 4.0-4.1 tcf.
Drilling activity has slowed but still remains strong, especially considering the persistent low pricing. The total natural gas rig count is 992, which is 44% higher than last year. Most of the increase in rig count comes from horizontal (primarily shale) rigs and the horizontal rig count is 110% higher than last year. A slowdown in the recovery of the economy has contributed to recent price weakness by slowing down the growth of commercial and industrial demand.
Market Outlook
The hot summer has led to some price spikes in the Eastern markets, causing the highest short-term prices since mid-2008. And, more spikes are possible, as the balance of August and September are both forecast to be hot.
The market appears to be taking a “wait and see” approach to several key risk points, including the hurricane season, an economic recovery and potential drilling cutbacks due to low prices. While predictions of an active hurricane season have not yet panned out, the peak of the season is still a month away. In terms of the economy, recent data suggests that an economic recovery will not be as robust as hoped, which is stifling industrial and consumer demand. In terms of drilling cutbacks, at current price levels, many traditional sources of natural gas are not economical to produce. Shale however has proven to be economical at these price levels and drilling activity has remained strong thus far. The strong domestic production levels, along with the weak economy, have led to high storage levels, albeit below last year’s record levels. This is contributing to low prices but the storage deficit reduces the likelihood of the market bottoming out in the fall like it did last year.
Despite strong U.S. natural gas production, supply balances are still vulnerable due to low prices. After summer projections of 4.0 Bcf/day, liquefied natural gas (LNG) imports have dipped below 1.0 Bcf per day, as cargoes have been diverted to other markets that pay higher prices than the United States. On a longer-term basis, Canadian imports are expected to continue their long-term decline due to falling production output.
Conventional or vertical drilling, which still comprises more than 60% of U.S. supply, is declining due to less attractive economics than shale. Risks also include higher usage from gas-fired electrical generation. If gas prices dip too low, gas-fired generation will be cheaper than coal-fired generation and demand will increase. This occurred in Q4 of 2009 and has the effect of keeping a floor on prices. The cheaper the gas, the more coal displacement will occur. Evidence suggests that switching begins to occur at $4.50. However, the opposite trend appears to have occurred when natural gas prices were above $5.00, which is one reason that the market has had difficulty trading above that level.
Fixed Price Customer Considerations:
Despite recent volatility, both near- and long-term prices remain at levels not sustained since 2001–2003. For customers waiting for a repeat of the 2009 pattern, which resulted in a final severe dip in prices in September, remember that last year was a very mild summer with a non-existent hurricane season. In addition, the economy was worse last year and there was less storage capacity, which resulted in a tremendous storage glut. A repeat of this scenario is unlikely. Prices are low now and buying now could help provide protection from the short-term volatility that is still possible for the balance of the summer.
Although still at a premium versus the near-term, long-term prices are at record lows and are worth considering. Remember, trying to time the bottom of the market can be difficult and if it is behind us, waiting for a return to previous lows could be a mistake.
Portfolio Customer Considerations:
Currently, Calendar 2011 can be locked in at levels near or below the 5-year day-ahead averages. Calendars 2012 and 2013 are also at all-time lows and remain an excellent value. Risks remain for shale gas because significant disruptions to shale production could return us to a higher price environment.
The current downward trend may cause hesitation in buying, but a less-risky approach is a gradual layer to ensure participation in the market’s current value, while allowing for additional purchases if prices fall further. If purchases are deferred, establish specific target prices and deadlines based on recent market movement and customer-specific price targets (budget, previous year costs, etc). Be sure to consider market risks, including extreme winter and summer weather and price correlations with broader markets, and don’t become paralyzed if the bottom of the market is behind us.
As always, consider your budget and/or year-on-year comparison and consult with your Portfolio Strategist regarding the appropriate strategy for you.
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