A sharp cold spell might spur a rally in gas prices on sentiment. Ultimately, though, supply-demand tends to prevail and early indications are that these fundamentals do not now support sustainable strength in natural gas prices. Supplies of distillate, from which heating oil is produced, are at their highest levels since 1999 and refiners are still producing this product, having switched capacity from lower-margin gasoline now that the heavy part of the driving season is over. That influences the natural gas market since many users can switch, almost at will, between oil and gas. Meanwhile, forecasters expect a warmer-than-usual winter in the northern parts of the United States.
Table A draws upon Commitment of Traders data collected by the Commodity Futures Trading Commission [CFTC] to show net long/short natural gas futures positions among commercial traders and non-commercial (investor) traders.
In oil, the investor track record has leaned toward buying high and selling low. It looks, at first glance, like they're doing better with gas; that they're buying low.
Investors and commercial buyers probably find it equally hard to second-guess the weather forecasts. But it also seems reasonable to assume that commercial buyers have a good sense of the range of their potential heating needs, as well as available supplies and experience procuring.
Given the price trends shown in Table B, we might also assume that if feasible for them to take more deliveries now, they'd do so considering how much lower the spot price is even when compared to near-term futures.
It is possible that commercial traders are liquidating futures positions and buying for immediate delivery. If that's happening, spot prices may continue rising until the $7.50-$8.00 range. But there's little reason to expect such a rally to proceed much, if at all, beyond that or that it might extend to the futures.
Table C shows how aberrant, on the downside, the spot market really is at this time. Futures presently trade at very substantial premiums to "fair value," which is calculated by adjusting spot prices based on expected carrying costs. When futures trade above fair value, a condition known as contango, it indicates the existence of a here-and-now surplus that is not expected to persist. (Other markets, like copper, reflect the opposite, backwardation, a current shortage that is expected to be cured at some point down the road.)
Generally speaking, we see erratic patterns as expectations fluctuate. In addition to basic supply considerations, gas markets need to take some account of oil prices — given that oil and gas are competitive sources of heating, the price of one will have some influence on the price of the other — and weather.
But despite the shifting sentiment, it's clear that the market has been no more willing to treat the mid-teens as an equilibrium price then they are the low-to-mid single-digit levels we've recently been seeing. A year ago, when the spot price was in the $13-$14 range, futures exhibited considerable backwardation. The market guessed, correctly as it turned out, that supply constraints which then existed, probably relating to hurricane damage, would not persist.
While we cannot point to any specific price as representing an across-the-board equilibrium level, it does seem that if we plug in $8.50 as a hypothetical spot level, most futures shown in Table C would wind up priced reasonably close to fair value.
Those in a position to invest in the spot market can still profit from such a move, assuming it doesn't get cut short by additional news on the supply-demand front. But even if spot prices continue to rally to a point near that level, investors in futures may find surprisingly few corresponding price changes.
At the time of publication, Marc H. Gerstein did not own natural gas-related derivatives or stocks. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
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