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Schork Oil Outlook: Iran, NatGas and Coal for Electricity

The volatility of natural gas prices has dropped precipitously. This is in line with prices decoupling from the rest of the energy complex. As such, chatter regarding the ability of gas to replace aging, less efficient coal-fired power generation is picking up.

To make things more interesting, yesterday Reuters reported that international oil traders Vitol and Trafigura joined their brethren at Glencore and have halted oil products sales to Iran. The move is in response to legislation pending in the U.S. aimed at Iran’s trading partners. Bottom line, this decision allows Tehran’s fast dwindling short list of oil products suppliers to demand an even higher vigorish.

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Thus, if Iran runs out of money to pay for gasoline and diesel imports, which usually occurs around October, then perhaps the country can switch to natural gas.

After all, according to the EIA, the overall price paid by electricity generating plants in the U.S. for fossil fuels was $2.94 per MMBtu in November 2009 (the latest date for which data is available), a 2.6 per cent decrease from October 2009 and a 10.4 per cent decrease from November 2008. Year-to-date (January through November) 2009 prices compared to the same period last year were up 7.8 per cent for coal, down 41.0 per cent for petroleum, and down 50.0 per cent (!) for natural gas, as illustrated in the graph in today’s issue of The Schork Report.

To wit, spot month Nymex Henry Hub gas futures have been in a virtual freefall of late. Firstly, the 30 day volatility (a measure wide enough to smooth out fluctuations yet capture short term trends) for natural gas stands as of yesterday at 37.28%, its lowest value since July 2008.

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In the months leading up to the pop of the commodity bubble, correlation between volatility and natty prices was a strong, negative (0.75) i.e. as natty prices fell, volatility rose. The relationship coincided almost perfectly with the pop of the commodities bubble – volatility bottomed out at 26.46% on the 2nd of July 2008, and natty prices peaked on the 3rd of July. In the months afterwards the relationship remained strong at (0.72) as volatility rose and prices fell.

Recently this relationship has reversed to a positive coefficient, as volatility and prices both decline. But the absolute value is even closer to one, at 0.89. This implies that an increase in volatility could potentially herald the return of the bulls and a recovery in prices.

The 30 day volatility is still hitting lows, but analysts at The Schork Report are also looking at the 5 day volatility, a more responsive yet less accurate measure. The 5 day for the April contract bottomed out on February 23rd at 12.8% and currently stands at 35.7%. As we said, such short term volatility is inherently less accurate, but traders should be looking towards an increase in volatility to signal a rebound in prices.

Meanwhile the EIA released its latest coal energy review at the end of last month. As of January 2010, coal production fell by 2.8 million short tons to 85.96 m/st. This is well below historical norms, 2010 production is currently 11.0% below 2009 and 11.3% below the 2004-08 timestep. Coal production seemed to bear the start of the recession well but began to suffer during 2009. For instance, January 2009 saw a 0.32% deficit to the preceding five year timestep, this widened to a 5.57% deficit by April and 9.01% by August before recovering slightly to 6.96% by December.

Thus January’s figure, at 11.0% is well below seasonal expectations. What’s more, imports for December 2009 (the latest data available) were 31.7% below 2008 and 16.7% below the 2003-07 timestep. However, there is no shortage of coal, either domestically or internationally. Coal exports as of December 2009 were 27% above the 2003-07 timestep but 25.1% below 2008. Further, coal consumption (made up of consumers and industry) for 2009 averaged 12.1% below 2008 and 11.4% below the preceding five year timestep.

The net effect of this push and pull has led to a net change in stocks of a 39.9 m/st increase in domestic coal stocks. The effect on prices is clear, the “dark spread” — the cost of generating electricity from coal, in this case the Big Sandy Coal in the Appalachian region — has been falling from a peak of 40 USD/MWH to a low of 7.6223 USD/MWH as of close yesterday, an 81% drop in price.

Thus while natural gas prices are falling, and stocks remain seasonally strong, we believe a similar scenario is in place for coal, making the switch from coal to natural gas at generation plants a very unlikely event. Perhaps in the long run, when increased LNG imports and shale production drive natural gas prices lower, utility companies can consider converting facilities, but that is a long way off yet. In the short term, traders should be looking at volatility to drive gas prices higher, not coal to drive prices lower.

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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.