A Look At Heating Oil Prices And Weather Futures

Includes: DNO
by: James Roemer

In an investment world in which "every little" news story or European hiccup moves many financial markets, it's good to know there are alternative investment opportunities. Weather and Climate have a multi-trillion dollar annual impact on global GDP. Commodity prices from natural gas, heating oil, grains, cotton, coffee and many others are greatly influenced by both optimal (bearish) and detrimental (bullish) growing conditions.

In the case of heating oil and natural gas, the incredibly mild early winter in both the United States and Europe is bad news for the ski industry but good news for consumers hoping for lower utility bills. One trade that I recommended a few weeks ago was being short heating oil heading into early-mid winter, due to unseasonably warm weather, seasonal factors and worries over the European economy. Historically, energy traders pay very close attention, not only to the weather here in the United States, but in Europe and Asia as well. Last year at this time, heating oil prices gained against crude oil and gasoline due to extreme heating demand in several parts of the world. Last winter, record snowfall not only hit parts of the eastern U.S., but China as well, in which a cold snap in China and Korea in December, 2010 created massive traffic jams, forcing schools to close in Beijing for the first time in years. Snow was the heaviest since 1951 in some areas.

WINTER 2010: Street cleaners use shovels to remove dirty snow from a main road near Tiananmen Square in Beijing. Photograph: David Gray/Reuters

SOURCE--DTN/PROPHETX: Heating oil prices last winter--soaring in winter

This season, the opposite is happening. The warm global winter is resulting in heating oil prices falling versus unleaded gasoline. As the chart shows, the price of heating oil versus gasoline has fallen from a 62 cent premium to under 30 cents over the last 4 weeks. Much of this warmth is due to the positive nature of the Arctic Oscillation Index (which I discuss below). Many weather forecasters blew the forecast a month or so ago, calling for a cold winter in the United States due to La Nina. However, what they failed to forecast was just one in a series of other teleconnections--the + AO index.


Seasonal considerations and heating oil's bearish move vs. gasoline prices

Seasonally, heating oil prices tend to fall during November and early December, and rally some later in the month. However, the recent slide in prices has gone further, due to the European debt woes and the warmer weather. Europe normally imports heating oil from the United States, but their demand has been affected. As the chart below shows, heating oil prices tend to bottom in mid-December. However, I expect in early 2012 the warm winter to continue and heating oil prices to stay under pressure, at least versus gasoline prices.

SOURCE: Moore Research

Heating oil and crude ETFs

While OPEC production and world economic factors have a huge influence on the price of crude oil, the continuing problems in Europe, combined with a warm winter and weaker than normal global heating oil demand, should mean that heating oil prices could fall another 10% or so this winter. Most recently, we have seen a bit of a rally back in crude prices and if European countries get their act together and the China economy can rebound, then crude prices could remain steady or rise in 2012. However, I would that heating oil prices will stay weak relative to crude and/or gasoline prices.

The short ETF (NYSEARCA:DNO) has seen about an 8% gain so far this month, and I would expect that further gains are expected in the weeks ahead, due to weak global crude oil demand. Probably the safest play is to find an ETF that one can sell heating oil versus crude oil or gasoline. However, buying this ETF (being short heating oil) may make good sense based on my world warm weather outlook.

Weather futures

There is even something called "weather futures" (based on temperatures) traded at the CME.

A trader can actually make a bet that it will be cold or warm at a host of U.S. and European cities. It doesn't matter if the dollar weakens, the trade deficit widens or there is a war or monetary collapse, trading weather futures are completely related "only" to the settlement price of a city's end of specific month temperature. In the near future, I will elaborate a bit more on this. But for those traders who want to be long crude oil and do not want to be short a crude or heating oil ETF, then being short temperature futures this winter is a great hedge.

SOURCE--Wall Street Journal/CME

Teleconnections that shape our weather

Teleconnections were first noted by the British meteorologist Sir Gilbert Walker in the late 19th century, through computation of the correlation between time series of atmospheric pressure, temperature and rainfall. They served as a building block for the understanding of climate variability, by showing that the latter was not purely random.

Indeed, the term El Niño-Southern Oscillation (ENSO) is an implicit acknowledgment that the phenomenon underlies variability in several locations at once. It was later noticed that associated teleconnections occurred all over North America, as embodied by the Pacific-North American teleconnection pattern.

One of the most important teleconnections in our winter weather is the Arctic Oscillation Index. This winter, the index is highly positive, meaning all the cold air is located over the poles. Forcing mechanisms from volcanic eruptions and changes in Sea Surface Ocean temps, can play a huge role on this index. When the index is positive (as it is now), look for warm weather in Europe and the United States to continue.

What is the AO index?

The Arctic Oscillation Index (AO) is one of the most positive I have ever seen it for November and December. In fact, there has never been a time since 1950 that this index had a monthly value greater than 1, for both November and also December. The closest years in which both November and December values were as high as today's were 1992, 1994, 1999. Interesting how all years were in the 1990's. The implications?

Probably warm weather continuing through much of January. This may continue to pressure natural gas prices and perhaps heating oil relative to Gasoline.

The AO index is influenced by a variety of very complex factors with regards to volcanic eruptions, solar activity, fall snowfall over Eurasia, etc. that create warming aloft when the AO then goes into a negative phase, or cooling aloft when it is in the present very positive stage. The last two winters, the AO index was very negative, which means that it was warm aloft near the North Pole and helped to push severe cold and snows down into the U.S. and Europe. This meant (for example), a gallant rise in heating oil prices early last winter as well as several Florida freezes that resulted in higher OJ prices. This winter, we have the opposite, a positive (+) AO index.

SOURCE: www.appinsys.com/GlobalWarming

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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