Buying Strategies

Compiled: January 5, 2011

Market Overview
Happy New Year!  An extremely mild start to the winter period, amidst ongoing strong natural gas shale production, resulted in large price declines and a huge natural gas storage surplus during December.  And, additional bearish news, including the delay of implementation of the EPA’s Cross States Air Pollution Rule, adds to the bearish sentiment.  The New York Mercantile Exchange (NYMEX) prompt month declined by 47 cents during December and fell below $3.00 for the first time since September 2009 and the 12-Month Strip fell as low as $3.24—a new 9-year low.

Calendar Strips for 2012–2015 fell by 37 to 52 cents per MMBtu during December and all posted new all-time lows as follows: 

Calendar 2012:  $3.24/MMBtu on (12-28-11)
Calendar 2013:  $3.93/MMBtu on (1-3-2012)
Calendar 2014:  $4.33/MMBtu on (12-30-2011)
Calendar 2015:  $4.59/MMBtu on (12-29-2011)

Weather
December weather forecasts were just as wrong as November forecasts, which had called for colder-than-normal temperatures for the eastern half of the United States.  Both cold and snow were lacking and resulted in severely-reduced heating demand for the Midwest and Northeast.  January may be a mixed bag of aboves and belows, but the first half of the month is expected to be above-normal and the subsequent forecast is still questionable.

Natural Gas Storage
The storage deficit of the summer is now a distant memory, as November injections and small December withdrawals have resulted in a huge natural gas storage surplus that has been a primary reason for the collapse of near-term natural gas prices.  As of December 23, domestic inventories are at 3,848 Bcf, which is 9.1% above the same time a year ago and 13.7% above the 5-year average.  Not only does this surplus provides a significant supply buffer for the winter in case of extreme weather, but a large end-of-winter carryout would reduced demand for summer natural gas storage refill programs.

Natural Gas Production
Natural gas production has been and should remain strong, with domestic output up by 6% versus a year ago. Total gas rig counts have fallen for the last eight or nine weekly reports and fell by 12% during 2011, but horizontal drilling was up 23% during the year.  Low prices have not suppressed new supply, as shale drilling efficiency (output/well) continues to improve and natural gas liquids (NGLs) supplement the revenues of “wet gas plays."  The continued addition of new reserves and construction of pipeline infrastructure have contributed to weakness of long-term gas curves. International imports via the Canadian Pipelines and liquefied natural gas (LNG) Tankers remain weak overall, with an ever-shrinking share of U.S. supply.  In fact, progress on the development of LNG export facilities continues to progress and appears likely for 2015 and beyond.

Other Factors:
On Dec. 30, a federal court ruled that  the Environmental Protection Agency (EPA) must delay implementing rules on interstate air pollution. Indications are that this ruling will allow several coal plants, particularly in Texas, to continue operations until at least April 2012, while casting doubt on its future implementation.  This ongoing operation of coal plants may reduce gas demand in certain regions.

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 a significant cost.  If coal plants are shut down due to changing economics, then this could increase natural gas demand to make up for the lost generation. 

Market Outlook
We are now into the winter period, so prices should be vulnerable to volatility due to any extreme cold weather—and there is plenty of upside with prices so low.  But overall, bearish fundamentals are still dominant for the short-term (storage surplus) and long-term (shale production).  Upside potential will continue to be limited by strong shale production, so any cold weather spikes may have a limited impact beyond the current month.  However, index power prices are always vulnerable to weather volatility in both summer and winter—as was experienced in both Texas and the Northeast during 2011.

If the winter does turn cold, there is 2012 upside risk due to declining gas-directed rig counts, as well as strong non-weather gas demand due to ongoing coal-to-gas switching (due to economics). Falling rig counts however are unlikely to have a significant impact unless actual productivity falls, which is not yet the case. 

At some point, downside movements will be limited by shale and non-shale drilling economics, as well as strong industrial demand. And, the correlation between gas and power prices has weakened in some regions—especially for Texas summer prices and Northeast winter prices.

Impacts of the U.S. economy, as well as competition between gas and coal in the generation stack, remain key factors in the direction of both near- and long-term prices.  But, international oil prices remain uncorrelated with gas and power and have recently posted 8-month highs. And, although they may be unlikely, extreme volatility could be caused by extreme geopolitical events, such as a war with Iran, or regulatory events, such as a ban on hydraulic fracturing due to environmental impacts.

Ongoing prices at levels far below the highs of 2008 are a more likely scenario due to shale gas production, although long-term risks, including drilling concerns, improvement by the U.S. economy, EPA regulations, and the potential for LNG exports, should not be ignored and justify the premium in the long-term forward curve.

Fixed Price Customer Considerations:
Prices for most regions are at their all-time lows. 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 only two months ago.  And, there may be less downside for 2013 due to the inherent forward market risk premium.

Waiting longer to lock in could result in lower prices but it also increases the risk of a market surprise, which is mostly skewed to the upside due to low prices.  This risk is greatest for 2012 and 2013, where there is less time for prices to correct.

Portfolio Customer Considerations:
As noted above, prices are at or near all-time lows and year-over-year savings may be possible. Dramatic short-term price spikes during 2011 caused by extreme temperatures demonstrated the risks of being un-hedged—so even customers with a high risk tolerance should consider hedges for certain time periods in certain regions (i.e. ERCOT in the summer; Northeast in the summer and winter).  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. If purchases are deferred, establish specific target prices and deadlines based on recent market movements, your specific price targets (budget, previous year costs, etc.), and consider market risks, including weather and environmental regulations.  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.