Yesterday’s issue of The Schork Reportstated that during last week’s trading “the bulls failed to hit [natty front month’s 50 day moving average of 4.373] on Friday which could lead to a technical sell-off this week.” Yet we were still surprised to see the severity of yesterday’s ~5.00% drop to 4.104.
Support came in around the 100 day MA of 4.093 and prices could not get lower than 4.101. We are trading around technical levels, but is there a fundamental reason for the weakness? Yesterday Commodity Weather Group came out with its intermediate seasonal outlook update, in advance of the more extensive outlook report at the end of the month.
The intermediate picture looks bullish in the short and long term. March 2011 is expected to be 21% colder than 2010, which would place heating degree days in 2011 13.44% above the 2005-09 average. Further out, summer is expected to trend hotter on the East Coast, though not quite as hot as last year. In the south, the hurricane season is expected to be busy and start early. So why the sell-off?
Consider that in October 2010 (the latest data available) natural gas as a source accounted for 24.96% of total electricity generation in the U.S. This is up from 23.64% in October 2009, 21.57% in 2007 and 13.73% in 1997. At the same time, total electricity generation has been trending higher, with 2009 standing 2.9% above the historical average. Needless to say, the electricity markets are a large and increasingly larger factor for natural gas prices.
Yet we are not seeing cold weather in winter and warm weather forecasts for summer being priced into electricity prices consistently. Sure, on peak spot prices at the PJM West spiked to $115.00/mwh on January 21st, well above January 2010’s highest price of $86.06/mwh as snowstorms battered the coast. In fact, it was the second highest value seen for January in the past decade, topped only by $126.50 in 2008 in the run up to the commodity bubble.
Yet this single day is skewing the rest of the month; if we exclude it and take average electricity prices at PJM West, the chart is much different, as illustrated in today’s issue of The Schork Report. The average electricity price in January 2011 came to $60.15, just 0.64% above January 2010’s average. From a historical perspective, prices are no longer the second highest, but the fifth highest, below 2008, 2009 and even 2004.
In turn, electricity output in the Mid-Atlantic region in 2011 was strong for certain weeks, but the January average stood just 2.72% higher YoY and 5.12% above the 2005-09 timestep. The lack of sustained high prices and electricity output comes despite January’s heating degree days in in the Mid-Atlantic standing 12.13% above 2010 and 19.59% above the 2005-09 timestep.
Contrarian traders may state that while natural gas is used somewhat to fuel electric heaters in the Mid-Atlantic, it is far more prevalent in the summer months when it is used to satisfy air conditioning demand. Yet the picture further out is no less troubling.
Keep in mind that electricity spot and forward prices do not have the same relationship as crude oil (or gold or cocoa) prices. The latter commodities can be bought today, transported, stored, insured and then sold off in the future. Thus for crude oil the price differential between spot and forwards incorporates not only future supply/demand but also the “cost of carry”. In contrast, electricity must always be moving, generated and consumed at the same time. Electricity cannot be bought at today’s prices and stored for sale at a later date. Thus there is no cost of carry, and forward prices are a more ‘pure’ measure of supply/demand.
Electricity forwards for July 2011 are not the most liquid contracts on the market, but current On Peak PJM Interconnect forward prices come to just $59.59/mwh, suggesting that the supply/demand ratio will not be much better in summer than it is today. Of course we will see inter-day spikes (as we saw in January) but traders do not seem concerned about generation shortages in advance.
The bottom line is that natural gas is locked in a bear market, and while we will fade spikes in either direction for technical trades, analysts at The Schork Reportare maintaining their bearish daily and monthly biases.
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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.