What a difference a year makes. Last year, we were witnessing a massive decline in industrial demand for natural gas, especially in the metal-bending states, as GM and Chrysler were in the process of shuttering factory floor space — the equivalent of around 450 football fields by one estimate. Thus, as demand for automotive steel sagged, North American steel mills had to idle furnaces so as to reduce existing inventories.
Per their 2008 annual report, U.S. Steel burned through the equivalent of 11,000 Nymex Henry Hub contracts that year, the equivalent of 1.3% of the average aggregate open interest; and, that was just U.S. Steel. Through the first quarter of 2009, steel mill capacity utilization rates were down to around 33% as opposed to 90% a year earlier. In other words, as blast furnaces turned cold, the demand for gas turned ice-cold.
What’s more, while chemical plant utilization rates did not suffer the same degree of destruction as steel, the declines were not insignificant, i.e., from around 77% in Q1 2008 to 69% in Q1 2009. Thus, Potash, one of the world’s largest fertilizer producers, noted that in North America “… potash fertilizer sales ground to a virtual halt as farmers seemed to expect a price decline similar to those in nitrogen and phosphate fertilizers, despite very different underlying fundamentals.”
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Therefore, the lack of demand in 2009 from automotive factories, steel mills, aluminum smelters, fertilizer plants et al. was acute… to say the least. As such, the extant purge in gas rig counts (mainly vertical trajectory) notwithstanding, the steep contango along the Nymex forward curve was giving a clear signal that the market was expecting demand destruction would outpace supply destruction through last summer and into the winter.
As far as this summer and next winter are concerned, the forward curve on the Nymex is again signaling weakness, albeit, for different fundamental drivers as gas rig counts (mainly horizontal) are up and industrial demand is off the nadir, but by no means robust.
In other words, 2009 is the mirror image of 2008: We can likely expect that supply construction will outpace demand construction through this refill season, hence the contango in the Nymex curve.
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For instance, let’s take a look at two key seasonal timespreads, the end-of-refill season Oct/Nov and the end-of-winter Mar/Apr. As illustrated in the April 23 issue of The Schork Report, the Oct/Nov spread contango is tracing along the bottom of the ten-year range. We would be remiss if we did not comment on two significant outliers: 2009 and 2006. For these two seasons the market was in über contangoes. In 2006, stocks were at record highs, 1.85 Tcf for the corresponding week, i.e., 22 Bcf greater than current levels. Last year stocks were also flush and as we just discussed, demand was virtually nonexistent.
Just by eyeballing this picture it is clear the Oct/Nov time spread trades on a bearish skew. Thus, regardless of the dog-days of summer, heavy hurricane seasons, stout economic growth, Amaranth… whatever, the October Nymex contract closes at a discount to the November. The degree to which this occurs depends on the degree of summer refills.
When the imbalance of supply over demand is severe (2006 and 2009) this relationship collapses prior to the expiration of the first leg of the spread. What’s more, if we once again eyeball this chart we see that this spread virtually always expires (at the end of September) lower than where it was trading in April. The one notable exception was 2005 when Hurricane Katrina decimated the GoM at the end of August of that season; but even then the October went off the Board at a discount.
For the Mar/Apr spread, there is a much greater degree of variance by virtue of the longer time horizon, but the skew is still bearish through the end of the calendar year, i.e., even through the coldest Decembers, the March trades bearishly to the April.
For example, the March (the last contract of the winter strip) trades at a premium to the April, but the skew in the relationship is negative as we move out along the x-axis. The current Mar/Apr is trading along the bottom of the ten-year range; aping the price path from a year ago. As you can plainly see, this spread is much more volatile than the Oct/Nov. In late July 2006 this spread blew out to (an unheard of, at the time) $1.30 premium as the $9 billion hedge fund, Amaranth tried (and succeeded) in driving the $500 million fund, MotherRock, out of business.
However, even those smart [sic] guys up in Greenwich and Calgary were not immune to the inevitable weakness in the March as the spread eventually crashed… taking Amaranth along with it two months later. This spread also spiked in 2003 (early start of winter deliveries) and 2005 (hurricanes Katrina and Rita), but the spreads weakened prior to the close of the year.
The Schork Report's bottom line: Key fundamental time-spreads are currently scraping along the bottom of their respective historical ranges. Thus, the market is showing little concern regarding this summer’s refills and next winter’s deliveries.
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Stephen Schork is the Editor of The Schork Reportand has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.