Beware of News Reports When Assessing the Forward Market

February 2009

• Lessons learned from the current market and the post-Hurricane Katrina market suggest large-volume energy buyers should not overlook their business objectives or be carried away by sensationalism in the press.
• In the current recessionary environment, today's relatively low commodity prices for short terms do not mean that prices for forward periods are also low.

Over the past year we have seen two ends of a market cycle - a bull and a bear. During the first half of 2008, natural gas prices appeared to be rising relentlessly. News reports made much of explanations referring to a discrepancy with crude oil prices based on energy equivalency and decoupling of economies such that economic growth from overseas would keep demand at rather high levels despite problems in the American economy. But by the end of the second half of 2008, the situation had changed diametrically with news reports now making much of explanations of demand falling faster than supply and the interdependency of large economies.

With these steep movements in price and punchy headlines with predictions of even lower prices, one could be forgiven for thinking that these trends would last indefinitely. Natural gas prices closing at progressively lower average prices every month since last summer do provide a temptation to adopt a strategy of waiting for even lower prices before entering the market. However, the behaviour of the market seems to run counter to this seemingly logical strategy.

As the charts below show, longer-term prices at AECO and NYMEX as of January 1, 2009 reflected an expectation that prices in the future will be higher as economies recover and demand rises to meet the growing needs of recovering industries. For many commercial and industrial energy buyers who purchase natural gas on a forward basis, delaying a purchasing decision as a result of focusing on the current short-term bear market may even be costly. In fact, the market is behaving as if prices are set to rise gradually and securing natural gas at some future point may end up being more costly than securing it now. It is also interesting to note that at the height of 2008's commodity bull market in early July, natural gas was trading forward at progressively lower prices. Therefore, securing natural gas at that time on the assumption that natural gas prices were destined to rise even further because of the emphasis on the discrepancy with crude oil prices and decoupled economies would have been an expensive decision in hindsight.

The experience of the past year is not unprecedented.

At the beginning of 2006, the US was still adjusting to the damage to production caused by Hurricanes Katrina and Rita in the autumn of 2005. However, North American markets were behaving as if the disruption was temporary and natural gas was trading forward at progressively lower prices. As it turns out, prices indeed fell as the year wore on as can be seen in the AECO and NYMEX charts below which compare the price curve on January 1, 2006 with the curves on July 1, 2006 and January 1, 2007. Securing natural gas at the peak of the crisis in January 2006 with doomsday scenarios of prices remaining high indefinitely would have been costly. Empirical evidence from the markets at the time was also providing some basis for questioning the validity of doomsday scenarios and strategies that were based on them.

Lessons learned from the current market and the post-Hurricane Katrina market suggest large-volume energy buyers should not overlook their business objectives or be carried away by sensationalism in the press. Natural gas buyers often purchase their natural gas requirements for periods of future consumption (e.g., one-year gas effective three years from present) and the prices paid for those periods of future consumption can often be very different from the spot prices whose extreme levels attract the most attention in the media. In the current recessionary environment, today's relatively low commodity prices for short terms do not mean that prices for forward periods are also low. It is more appropriate for energy buyers to view the market using a time horizon that suits their business needs and practices, and to refrain from making long-term business decisions based on information that is applicable to the short-term.

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