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Much like farmers looking across fields seared by drought, my poor trader friends almost despair of seeing volatility return to their markets. OK, they’re not poor, but they complain as if they were becoming poor.
So I’m going to offer a suggestion, like an annoying government agricultural agent advising sceptical locals to switch to crops more in demand. Buy natural gas or, rather, the volatility embedded in natural gas contracts. Natural gas, basically methane, has long been one of the more volatile commodities and, while there are bulls and bears on the direction of its price, they agree that it will get more volatile. You have to learn more about the way business works, but knowledge is good, right?
While natural gas is less of an international commodity than metals or crude oil, the various continental and national markets are more connected than they were. The US is still the most important market, because it produces and consumes so much from diversified sources and has more storage facilities than Europe or Asia. Its users have more flexibility in taking or not taking internationally traded gas that comes in the form of liquefied natural gas.
If Europe had an energy policy, which, in spite of many white papers and speeches, it does not, it would be building a lot more gas storage facilities and diversifying supplies more rapidly. So what is going on with the US market that has not been efficiently discounted?
Air conditioners and hurricanes.
The biggest single use for natural gas is electricity generation. While the trend line of economic growth in the US has slowed, electricity consumption has taken an unexpected upturn. The reason, power people will tell you, is the sub-$100 air conditioner. Thank Chinese workers and efficiencies of scale.
For more than a year now, you have been able to go into a discount store and buy a room air conditioner for less than two days’ pay at minimum wage. Then you can sleep as comfortably as rich people do in the fierce American summer. Most below-the-poverty-line households in the US now have air conditioning.
Consequently, in many parts of the country with growth depressed by the housing market, electricity demand in peak hours is growing at 3 per cent annually. Power demand growth is also driven by falling prices for computers and plasma-screen televisions, both power hogs.
There were a lot of gas-fired generation plants that looked like dead weights around their creditors’ ankles a few years ago. Now they are being run to the point where the operators worry about finding time for needed maintenance.
Then hurricanes. Last year was a good year from the point of view of Florida homeowners and a bad one for holders of long positions in natural gas. “In 2006 we had an El Niño weather pattern,” a gas trader explains, “which is less likely to lead to hurricanes going from the Atlantic, across Florida, to the Gulf of Mexico,” where much US gas production capacity sits. “This year we have a La Niña pattern, which is at least 25 per cent more likely to generate storms that get to the Gulf of Mexico.”
Bad for Florida homeowners. Bad for natural gas short positions. In the average year there are weather-related losses of 50bn cubic feet of gas production.
Hurricanes Katrina and Rita cumulated in more than 1,000bn cu ft of shut-in production, which led to 2005’s gas-price peaks of about twice today’s level.
The probability distribution tells us a repetition of that is unlikely, but a multiple of the average shut-in level is not a bad bet, what with La Niña. So you have a relentless increase in demand, with power and gas users dicing with death in the form of La Niña.
There has been some increase in US storage capacity, paid for by private equity investors looking for something to do with their money. Not all of that is close to the consumers, who want power but not neighbouring storage facilities.
Other market factors tend to press in the direction of higher prices. The expensive gas of recent years is conjuring up more production in Texas, but geology and internal demand have led to offsetting cuts in Canadian exports to the US. Also, while there was a large increase in LNG imports to the US in the first five months of the year, to about 4bn cu ft a day, this month there will be a reduction of half a billion cubic feet of capacity as an import facility at Cove Point, Maryland, is taken offline to allow expansion work.
A large gas production platform in the Gulf of Mexico, the Independence Hub, was supposed to come on line in time for summer. When completed, it is supposed to provide about 1bn cu ft a day of production. But reports from the field indicate that its provision of anything close to that level will be much delayed, probably to late this year or early next year.
The builders are technological pioneers of construction in deep water. Like many pioneers, they got some arrows in their backs, here in the form of tricky deep-water currents. That is a little more than 1.5 per cent of potential daily supply that will not be there in time for summer deliveries.
There is, of course, a bear case for natural gas. Bruce Henning, who models the gas market for Energy and Environmental Analysis, the Washington-area consultancy, says: “The market may be overestimating the weather impact on this year’s natural gas supply. What if we just have the 50th percentile occurrence, which is 50bcf [billion cu ft] of lost production? Also, we don’t share the concern about excess storage capacity. [With cool weather] you could see more gas in storage, and then a lot of gas production hunting for a home.”
Mr Henning could be right. So could the gas bulls. Both sides agree that supply and demand are finely balanced. Which is where the volatility bet comes in.
“Right now,” a hedge fund gas trader says, “the at-the-money volatility implied in the September contract is around the 48-49 per cent level. A year ago it was closer to 68 per cent. The mean is closer to 55-60 per cent. Today’s levels are low.”
They were depressed in part by the Bank of Montreal’s liquidation of a couple of now unemployed traders’ positions. It didn’t kill the bank, but the unwinding depressed the price of volatility. And any price break, up or down, increases the level of volatility. So you whining and moaning hedgies and prop traders out there have been given a cheap entry point.
Worth a look.