Early this week, as we predicted might occur in last week's Market Report, both the spot market price for natural gas and prices in the NYMEX futures market jumped sharply. Prices in the Day Ahead market at Henry Hub reached as high as $ 6.23/MMBTU on Tuesday, May 4th; the January 2005 natural gas futures contract briefly traded at a new contract high of $6.83/MMBTU and closed the day on Tuesday at $6.085/MMBTU - within striking distance of the $7.00/MMBTU mark.
With NYMEX crude closing at $39.57/barrel today, the stage now appears to be set for further increases in natural gas prices this month and even higher prices this summer.
In this week's Report, as I do every week, I'll review what’s happening in the market and what to expect next. This week, however, I've decided to break from the normal pattern, and spend most of the Report trying to step back and look at "bigger picture" issues regarding where the natural gas, electricity, coal and oil markets are likely to head over the remainder of the year.
My reason for doing so is this:
Every week when I prepare my Weekly Report, I try my best to present a balanced point of view.
To the extent time and space permit, I usually try to present both the "bullish" and "bearish" case as to what might happen next in the market. I do this in part because, no matter how strongly the fundamentals might dictate that prices move in a particular direction, the market can and often will take a different perspective.
It is essential, therefore, at all times to be mindful of how those different perspectives might drive the market at any particular point in time.
At the same time, over the past several days, it has seemed to me increasingly that, in focusing as I often do on the normal week-to-week metrics, and discussing how the Weekly Storage Report and/or other specific pieces of data might be interpreted as “bearish” or “bullish” indicators, like many analysts, I may sometimes risk losing sight of the forest for the trees.
In this week’s Report, I certainly will continue to try my best to maintain my objectivity and balance.
Over the past few days, however, as I’ve tried to step back and look at “bigger picture” issues, a number of factors stand out that cause me to conclude that, as high as natural gas prices may be currently, we still are virtually certain to see steep further increases over the remainder of this year – quite possibly beginning very soon.
The specific factors that cause me to reach this conclusion are discussed in detail in the Market Analysis & Commentary Section of this Report. They include, however, the following:
At the same time, the manufacturing sector is showing far more strength than it was a year ago, and certain natural gas intensive industries (including the steel and aluminum industries) are showing an extraordinarily high rate of growth.
As a result, while there have been declines in natural gas consumption in certain specific industries, on an overall net basis, manufacturing sector consumption of natural gas almost certainly is at least as high as it was a year ago and quite possibly higher. The likelihood that there has been a major net reduction in manufacturing sector use of natural gas appears to be remote.
This is in part because, in the limited circumstances in which oil potentially can be substituted for natural gas, oil is significantly more expensive than a year ago and in any event may be precluded from being used due to environmental restrictions during the period from May 1st through the end of September (i.e., the ozone “non-attainment” season).
More importantly, however, in most instances, it is because the U.S. economy is much stronger than it was a year ago and because the value of the dollar has declined. As a result, manufacturers are less likely to curtail production and have more ability to pass through increased costs for natural gas.
Currently, many analysts are putting great stock on the fact that the amounts of natural gas in underground storage as well above year-ago levels. (As of last week, for example, the amount of natural gas in storage was a whopping 401 BCf – or 53 % -- above last year’s levels.)
This huge surplus, however, is less significant than it seems, for at least four reasons:
Except for last year, the only other year when the same-week figure was lower was April of 2000, when storage as of the same week was 947 BCf (208 BCf below last year’s level). That year, of course, like this year, the economy was booming. Notably, even though U.S. production was then at its peak (with total U.S. production at least 1.0 TCf above current levels) , by the end of the year natural gas prices quadrupled – with the spot market price for the first time exceeding $ 10.00/MMBTU.
As discussed in earlier Weekly Reports, these milder temperatures resulted in a massive year-over-year decline in power sector demand for natural gas in June and July, particularly in the East North Central Region, the Mid-Atlantic Region, the Southeast Region and the South Central Region, which was largely attributable to weather.
This year, however, there is no reason to expect a similar weather-related decline. Instead, there is substantial reason to expect a steep year-over-year increase in power sector consumption of natural gas during the same period, since the economy is growing at a rapid clip and consumption during the same months in 2003 was depressed by atypical weather in core urban areas, where most of the summer air conditioning load is centered.
These increases in power sector demand for natural gas could be even steeper if temperatures are hotter than normal and/or operation of some coal-fired plants is curtailed, as some forecasters are now predicting will occur.
This reduction in required purchases by the LDC’s clearly is helpful. In the final analysis, however, it will offset only a small portion of the increase in demand in the power sector that has occurred since last year and will not compensate at all for the further declines in production that have occurred over the same time period.
In the end, therefore, I believe that the evidence is unmistakable that the supply/demand balance in the U.S. market is deteriorating rapidly, and that a substantial further price adjustment will be required to bring the market back into equilibrium.
An academician (which I decidedly am not) will doubtless object to the assertion I have just made that a major further increase in prices is necessary to bring the market back into equilibrium, and claim instead that the market (being efficient, as academicians assume every market is) must be aware of all that I have just said and already must have priced all of the factors I’ve identified into the market price of natural gas.
And it is, of course, possible – at least in theory – that this is exactly what has occurred (i.e., that the effect of the recent run-up in futures prices and the accompanying run-up in the cash market price is to price into the market everything I have just described).
Only time will tell whether this has occurred.
My own experience over the past several years, however, is that most oil and gas analysts still thoroughly misunderstand the impact that changes in power sector demand for natural gas have had on the natural gas market – even though these changes have been the most important factor affecting the market for several years, played a particularly critical role last year and, if anything, are likely to play an even more important role in 2004. I’ve yet to read any analysis that, at least in my judgment, correctly evaluates the factors listed above.
If the full-time professional analysts who follow the industry most closely, however, are far off the mark in assessing factors affecting supply and demand, its difficult to see how the market as a whole could nonetheless be expected to accurately price in the dislocations described above – especially since the market has never previously experienced dislocations of quite this nature or magnitude.
Instead, my overall sense of how the market is currently pricing natural gas is quite different.
The cash market price currently is at an all time high for the first early May. Earlier this week, most months’ futures contracts’ also set new contract highs.
At the same time, however, despite these extraordinary circumstances – and despite the fact that oil prices are at a 13-year high – I believe that fundamentally the market as a whole is quite skeptical of the fact the potential for natural gas prices to go any higher.
In other words, despite all of the evidence discussed above that the natural gas market is likely to get even tighter as we move into the summer air conditioning season – i.e., that the economy is booming, that supplies are continuing to decline and that electricity demand is running far above last year’s levels – fundamentally the market is acting as if prices are likely to top out very near to where they are now, with very little likelihood that prices will go much higher.
Notably, for example, a heart-of-the-summer August natural gas futures contract, covering a period when power sector demand for natural gas is likely to average 4 to 5 BCf/day higher than it is in June (and on some days could wind up being 10 BCf/day higher), and the economy will have experienced 60 days of additional growth, is still selling for only about a 10 to 12 cent/MMBTU premium over a June contract, when the pressure on the spot market price is not likely to be nearly as intense.
Similarly, the premium for moderately out-of-the money August or September call options is also relatively small (and, at least as we calculate it, significantly under-priced using the Black-Scholes Model for pricing options) -- even though the volatility for natural gas contracts is huge.
Further, the NYMEX futures market generally has been proceeding very gingerly each time it approaches a new resistance point.
In a sense, this skepticism on the part of the market is healthy; it suggests that the market is less likely to race upward in runaway fashion than it has at times in the past (and therefore hopefully will be somewhat less prone than it has been in the past to sudden collapse).
At the same time, at least in my judgment, it suggests that the market has not yet really begun to price in the fundamental drivers listed above.
Much has changed since I first started writing these Weekly Reports 10 months ago – almost none of it for the good (in terms of there being any reasonable basis for hoping that increases in natural gas prices can be kept within tolerable limits during the remainder of this year).
The economy, which had been dormant for so long that it was becoming unclear whether it would ever revive has taken off with the strongest burst in the manufacturing sector in almost 20 years (fueled in part by the end of the war risk and by U.S. funding of the effort to rebuild Iraq). This is great for the welfare of most Americans. However, it inevitably means significantly higher industrial consumption of natural gas than would have occurred otherwise and is also leading to the strongest growth in electricity demand in decades.
Further, this strong growth in electricity demand for the first time is occurring at a time in which we are now totally dependent upon natural gas-fired generation to meet virtually all of our incremental electricity requirements in many regions of the country during an increasing number of hours every year.
At the same time, over this same 10-month period, both U.S. and Canadian natural gas production – which collectively account for 98 % of U.S. supply – have deteriorated at an even more rapid rate than even the most pessimistic among us feared.
And oil prices are almost 50 % higher than most experts were predicting just a few months ago.
Despite all of this, the cash market price is still priced below where it was on May 15th of last year – and until earlier this week, within 30 to 40 cents/MMBTU of where it has been priced for most of the past 12 months.
Fundamentally, therefore, I do not believe that the market has yet priced in any meaningful way the dislocations that are about to occur over the next 60 to 90 days.
Instead, I think that was has happened is that, twice now – last May and June, and again this past December and January – the market has skated to the edge, in the sense that it raced towards very high prices (i.e., a peak of $ 6.41/MMBTU in the cash market last summer, long stretches between $ 6.50 – 6.75/MMBTU this past winter) and then pulled back.
Both times, as both Matt Simmons (who I admire greatly) and I have each separately written about, “good luck” regarding the weather kept us from going over the precipice (i.e., kept from prices exploding to much higher levels).
Last summer, it was the mild weather in the urban centers in the east in June and July (along with a number of other factors discussed in the earliest of my Weekly Reports). This past winter, it was a combination of very mild weather in November (which allowed us to build up an extra storage cushion of around 125 to 150 BCf in November), mild weather in late December and early January, and decisions by LDC’s beginning in mid-January to begin pulling down heavily on storage in the East Consuming Region, relieving the pressure on the spot market price of natural gas (but increasing the burden these same LDC’s will face in refilling storage now).
In each instance, however, if weather-related demand had been just a little bit greater, prices easily could have been pushed much higher.
The “market,” however, didn’t fully appreciate in either instance just how close we came to seeing $ 8.00/MMBTU prices – and similarly isn’t yet pricing in now any recognition of how close we are to seeing $ 8.00/MMBTU prices again.
This time, however, I believe circumstances are different than the last two times we “skated towards the edge,” in at least two important respects:
All of this has potentially startling implications for the market. When energy supplies become scarce prices don’t tend to rise just modestly; instead, several-fold increases in price are not unusual.
I am not suggesting that we will necessarily see natural gas prices double this summer or even that prices will necessarily reach $ 10.00/MMBTU – although they easily could.
What I am suggesting, however, as clearly and starkly as I can, is that this summer:
To the best of my knowledge, however, very few companies are taking these steps.
Dow Jones newswire reported today that electricity production for last week was 69,245 Gigawatt hours – 1.6 % greater than last week and 6 % higher than the same week last year. (Note that the weather-related load both years was very similar.)
Last year, electricity production did not reach this level until mid-June.
This year, by mid-summer, electricity production could average 3,500 to 4,000 GWhrs per week higher than last summer every week – and could be up to 10,000 GWhrs higher than last year in some weeks if we have any “killer hot” summer weeks (which by and large last summer never occurred).
By late July, it is possible that we will have a series of weeks in which we will set a new U.S. record for electricity production every week for several successive weeks, with virtually all of the incremental electricity production compared to last year served by increased use of gas-fired generating units.
It is even plausible that in one or two weeks this summer we could have a small net withdrawal from storage rather than the typical summer-time injection.
As we’ve discussed in the last several Weekly Reports, these figures carry an important – I believe critical – message for the industry.
In a natural gas market that is tight as a drum, with supply declining and the manufacturing sector humming, it is not realistic to expect that we can have increased pressures on the natural gas market of this nature without intense upward pressure on the price of natural gas – and therefore, in the summer months, the wholesale price of electricity as well. Under these circumstances, the 40 cent/MMBTU increase in the spot market price that occurred earlier this week could soon look tame.
It is essential, therefore, that more companies begin paying attention to this message at the earliest possible date.