Buying Strategies

Compiled: April 23, 2012

Market Overview
Market sentiment continues to be bearish. The front-month contract finally fell below the $2.00 resistance barrier, hitting a level not seen since September 26, 2001. In addition, all Calendar Strips established all-time lows. The U.S. has entered the so-called shoulder season, when consumers turn off heating but do not yet need air conditioning and gas inventories have historically increased over this time period. Market sentiment, particularly in the near-term, will remain bearish unless production cuts are meaningful and sustained.

Calendar Strips for 2013–2016, on average, fell approximately 25 cents per MMBtu since the beginning of March 2012, posting new all-time lows as follows, as of this writing: 

(all prices are in MMBtu)
May 2012 (Prompt Month):    $1.95 on 4/18/12
Calendar 2013:                        $3.30 on 4/18/12
Calendar 2014:                        $3.76 on 4/18/12
Calendar 2015:                        $4.02 on 4/18/12
Calendar 2016:                        $4.25 on 4/18/12

It is important to note that falling natural gas prices are not necessarily resulting in substantially lower electricity prices. The impact of falling natural gas prices on electricity prices is diminishing, as regional heat rates (the ratio of gas to power prices) rise.  

Heat rates have risen for many reasons including regional electricity fundamentals, such as the possibility of higher ERCOT price caps and potential nuclear outages in southern California, as well as impacts of non-fuel costs of generating power.  In some cases, electricity prices are approaching the point where plant operations represent the bulk of the variable cost of generation and therefore falling gas prices have a reduced impact on power prices. 

Market Fundamentals

Weather
According to the National Oceanic and Atmospheric Administration (NOAA), March 2012 was the warmest March on record for the contiguous United States, breaking a record established in 1895. Some places in the Midwest averaged more than 15 degrees above normal for March 2012.
It is worth noting that random and short-lived temperature swings in the “shoulder season” between the peak winter heating and summer cooling demands are essentially neutral for the market.

The forecast for May 2012 calls for widespread above-normal temperatures across much of the eastern half of the U.S. and back into the Southwest. The forecasts for June 2012 are calling for have warm temperatures in the Plains states and back into the Southwest, with near-normal temperatures in the East.  Very preliminary forecasts for summer 2012 are calling for above-normal temperatures in the eastern half of the U.S. early in the summer before the core of the hot anomalies shifts toward the West and Mid-continent.

Preliminary and very early projections by MDA Earthstat for Atlantic hurricane season are predicting 11 tropical storms, five hurricanes, and two major hurricanes. These projections are slightly below-normal for tropical activity and noticeably less than last year.

Supply and Demand
As of April 13, 2012 domestic storage inventories were at 2,512 Bcf, which is 53.1% above the same time a year ago and 57.7% above the five-year average. Current inventory levels at this time of the year are at record highs. We didn’t reach the current inventory level last year until June 2012. Assuming that there is no summer demand surge, inventory levels are projected to exceed the U.S. capacity of 4.1 Tcf sometime in early fall.  In fact, normal injections would result in inventories near 4.6 Tcf, which is far above capacity― in other words, normal injections are not possible.
Natural gas production continues to be strong despite announced production cuts by major producers. It is unknown at this point whether the cuts are being fully implemented and/or big enough to counter smaller producers.

Natural gas rig counts continue to fall (22 of last 26 weeks). In the past, rig counts were a strong indicator for future natural gas production. Unfortunately, this relationship between the two is deteriorating for two reasons. First, current natural gas rigs are much more efficient than rigs of the past. Second, the high price of petroleum has increased the amount of rigs drilling for petroleum. Many of the formations in which the increased drilling is occurring are yielding natural gas as a by-product. Consequently, natural gas from this drilling is saturating the market despite the falling prices.

Environmental and Regulatory
The U.S. Environment Protection Agency (EPA) continues to play an active role and has taken several recent actions regarding the gas and power industries.

• On April 18, 2012, the EPA released new regulations, starting in 2015 that are designed to the limit the release of smog-forming chemicals and other toxic substances that may escape into the air during oil and natural gas drilling.  However, this regulation was expected and did not contain any surprises and there was no significant market reaction.
  
• On April 1, 2012, the EPA dropped its claim that an energy company contaminated drinking water in Texas, the third time in recent months that the agency has backtracked on high-profile allegations linking natural gas production to water pollution.
  
• On March 28, 2012, the EPA announced new rules that will limit carbon dioxide emissions from new power plants and that will effectively block the construction of new coal-burning power plants and make natural gas even more attractive as a fuel for generating electricity. 
  
• On Dec 30, 2012, a federal court ruled that the EPA must delay implementing its Cross States Air Rule (CSAPR) until at least April of this year. This ruling has allowed several coal plants in Texas to continue operations, while casting doubt on its future implementation. Since we are well into April 2012, it is unlikely that the (CSAPR) rule will be implemented prior to the upcoming summer period―much to the relief of ERCOT market participants.

Meanwhile, the EPA released details of the Mercury and Air Toxics Standards (MATS) that will regulate emissions of various toxins, including mercury, from coal plants at significant cost. If coal plants are shut down due to changing economics, then this could increase natural gas demand to make up for lost generation. Recognize that the MATS implementation date is not until at least 2015 but is expected to have a very significant market impact when it does go into effect.

According to a study published in the Proceedings of the National Academy of Sciences, natural gas appears to be more environmentally friendly than coal for generating electricity even when methane leaks are accounted for.  However, the study questions the use of natural gas in cars and heavy-duty trucks because of the rate at which the methane leaks in the so-called well-to-wheel cycle.

Market Outlook
Overall, the market is oversupplied at this time and this has contributed to plummeting near-term prices.  Something must happen to rebalance the market to avoid storage inventories exceeding capacity.  Three potential ways to rebalance the market are:

• increased demand from weather
  
• reduced supply by production cuts
  
• increased demand from coal-to-gas switching

Both production cuts and coal-to-gas switching are dependent on low prices.  None of these factors is likely to drive the market on its own and there are other factors that can impact market balances as well.  Falling rig counts are unlikely to have a significant impact unless actual productivity falls, which is not yet the case.  However, the recent trend in rig counts and production cuts announced by producers have provided long-term price support and warrant close watching.

A key concern of the EPA rules is that coal generation would be shut down and replaced by natural gas.  But, due to current fuel economics, this switching is already occurring on a widespread basis.  Permanent shutdown of the plants would increase baseload gas supply and could also impact non-wholesale power costs, such as ancillaries and transmission rates, in order to maintain grid stability and to add new infrastructure.

Index power prices are always vulnerable to weather volatility in both summer and winter (recall the strong prices for both Texas and the Northeast during 2011).  And, the correlation between gas and power prices has weakened in some regions―especially for Texas summer prices and Northeast winter prices.  Texas is especially vulnerable if rate caps are raised, which is expected to occur.  Watch heat rates, which are an indicator of whether gas and power prices are moving together.

Long-term prices are a much more complex question.  Movement to the upside is clearly limited due to huge natural gas reserves that are available with break-even economics in the $4-5 range.  Meanwhile, $2.00 gas does not appear sustainable long-term, as there could be more (1) producer cuts (2) coal-to-gas switching (3) growing industrial demand (4) likely liquefied natural gas (LNG) exports by 2015 and (5) increased use of natural gas vehicles eventually.  Although it is unclear when these factors may become a reality, the gas market has traditionally followed a “boom to bust” cycle, where low prices eventually lead to a strong rebound and price volatility.

Fixed Price Customer Considerations:
Prices for most regions are close to their all-time lows.  And, while waiting has been the best strategy for the last three years, recent news and trends, including reduced drilling by producers and rising heat rates, have resulted in a more balanced outlook going forward.

Are you able to lock in year-over-year price savings or beat your budget?

Recognize the value in the long-term, despite its premium.  For example, although 2013 gas prices are at premium versus 2012, they are at a level that was first attained by 2012 prices a few months ago.  And, there may be less downside for 2013 due to the changing fundamentals noted above.  Waiting longer could result in lower prices, but it also increases the risk of a market surprise, which is mostly skewed to the upside due to the already low prices.  This risk is greatest for 2012 and 2013, because there is less time for prices to correct.

Portfolio Customer Considerations:
Dramatic short-term price spikes during 2011 caused by extreme temperatures demonstrated the risks of being un-hedged therefore even if your business has a high risk tolerance, it is important to consider hedges for certain time periods in certain regions (i.e. ERCOT summer heat and ongoing drought and the Northeast summer and winter timeframes).

With summer just around-the-corner, now is the time to put in place any defensive hedges before the summer heat and hurricane season.  And, because the relationship between power and gas prices became less reliable in some regions during 2011, it is riskier to rely on natural gas as the basis of a power procurement strategy.  Recognize that further gas declines may or may not result in lower power prices.

Although there is a premium for 2013 over 2012 (and 2014 over 2013), recognize the various bullish risks that justify this long-term premium and that are likely to be sustained.  The Portfolio product’s layering capability is a perfect tool to lock in value at all-time lows, while leaving room for subsequent layers or day-ahead participation as part of an aggressive strategy. 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.