Buying Strategies for a Volatile Market
Compiled: June 10, 2009
Market Overview
After trending consistently downward for most of the previous 10 months, natural gas and electricity finally showed some resilience. NYMEX natural gas futures reached a six-year low of $3.15 on April 27 but have traded within a range of $3.15 to $4.50 since then. May natural gas futures expired at $3.538, an increase of $0.12 or 3 percent during the month. Natural gas prices have been pulled higher by rising crude oil prices and pushed lower by record storage inventories and weak demand. Crude oil, now over $70 per barrel for the first time since last November, has rallied due to optimism that a recovering economy will spur demand and concerns about a weak dollar and inflation.
Meanwhile, natural gas storage continues to fill at a record pace. Domestic inventories were at record levels through May and are on-pace to surpass all-time highs going into the winter and possibly even challenge capacity limits. Such a storage glut could push spot prices significantly lower, as either increased demand or reduced supply would be necessary to balance the market. In addition, competition between natural gas and coal for power generation load has provided price resistance in the $4.00–4.50 range for natural gas.
Long-term natural gas prices continue to reflect a more bullish market outlook due to optimism regarding the economy and evidence of a negative supply response to sustained low prices. Natural gas drilling activity, as evidenced by the rig count, is down by over 50 percent compared to a year ago. But, actual supply output has been slow to follow due to the time lag of exploration activity, in addition to improved drilling efficiency.
Electricity prices have followed the same trend as natural gas, with long-term prices—especially 2011 and beyond—commanding a very significant premium versus near-term.
Market Outlook
The market was due for a bounce and the prompt month could remain in the $3.50—$4.25 range but eventually the storage surplus problem must be solved. Summer heat or hurricane storm damage are always factors for causing price increases, as are the impacts of a stronger economy or reduced drilling. But, each factor on its own is unlikely to be large enough to solve the overhang before October. Otherwise, near-term prices must fall to shut-in production or to stimulate demand.
Currently, weather forecasts are calling for milder temperatures and fewer hurricanes than a year ago, but it is very risky to rely on long-term weather forecasts as price indicators. Although to a lesser extent than a year ago, the impact of the investor community has increased. Passive investors have been buying various commodity funds that create a supportive effect on energy prices because they have a naturally long position in the market.
For the longer term, the economy remains the primary market driver—this has not changed. More bullish long-term fundamentals remains in place, including a better outlook for economy and potential supply response, therefore it is very possible that long-term prices have reached their lows. But, even if the recession continues, we do not expect 2010 prices to reach 2009 lows due to declining natural gas drilling activity. The most bullish scenario is a simultaneous recovery by the economy and a decline in supplies.
Another more concerning scenario would be the decoupling of short- and long-term prices due to the conflicting market drivers. This is less likely for 2010, which should reap the benefit of a carryover of the storage surplus, but it is a possible in 2011 and beyond. The contango forward curve that is already in place does diminish the likelihood of this scenario however.
Fixed-Price Customer Recommendations:
Our recommendation for fixed-price customers is mostly unchanged. Prices have maintained the bulk of the value gained over the last nine months. Prices for the remainder of 2009, as well as 2010, still present an excellent value.
If a customer is unable to transact for 2010, they may want to lock in 2009 through the summer, at minimum, to protect against the risk of summer heat price spikes. For 2011, prices are higher, but the risk-reward balance is more balanced and there may be potential to fix long-term prices at attractive prices. If you wait, be sure to set a realistic price target.
Portfolio Customer Recommendations:
Recent price action has identified resurgent risks to the upside, which support buying initial layers at a minimum. Remember that a hedging strategy does not try to pick the bottom but rather it focuses on locking in value and managing risk. If hedge levels are extremely low, recognize that there is still excellent value based on the extent of overall prices declines since July 2008, as well as the forward curves over the last five years. We continue to recommend base hedge levels for 2009 and 2010.
If higher hedge levels are being considered, as well as hedges for 2011, customers should consider their own goals, risk tolerance and business constraints, in addition to market conditions. Balance the risk of further upside versus the possibility that the current rally could be reversed by a storage glut or enduring recession.
If purchases are deferred, establish specific target prices and deadlines based on recent market movements, your budget, previous year costs, etc., and consider market risks, including summer weather, hurricane season and price correlations with broader markets.
As always, consider your budget and/or year-on-year comparison and consult with your Portfolio Strategist regarding the appropriate strategy for your business.
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