Volatility set to return to US natural gas market, warn analysts

Booming shale production has brought US natural gas prices to 10-year lows and dampened market volatility, making life difficult for traders. But with rising demand from industrial users, power generators and exporters of liquefied natural gas, volatility could well make a comeback, argue analysts. By Alexander Osipovich

Natural gas outlook

US natural gas was once a notoriously volatile product – and traders who made big bets on market swings could expect to reap either handsome fortunes or eye-watering losses. In the past few years, though, the boom in unconventional production has made life much more boring for traders. As a proliferation of cheap shale gas has lowered prices and dampened volatility, many market participants have suffered from a decline in trading revenues, while banks have also been hit by a lull in client hedging activity. Consequently, many traders have simply lost their jobs.

"It's difficult for natural gas traders to find positions, because there is less money to be made in the market," says Peter Henry, New York-based head of front-office search at Commodity Search Partners, an international head-hunting firm. "There is definitely some retrenchment going on."

Of course, for many consumers and market participants, the emergence of shale gas has been resoundingly positive. Thanks to the new technology of hydraulic fracturing – or fracking – and improvements in horizontal drilling, energy firms have unlocked vast troves of natural gas embedded in shale formations, which had previously been too expensive to extract. That has brought about a new era of low prices. Over much of the past 18 months, the spot price for natural gas at the Henry Hub distribution point in Louisiana has been stuck in a range between $2-4 per million British thermal units (/MMBtu), dropping to a 10-year low of $1.82/MMBtu in April 2012, according to the US Energy Information Administration (EIA). Beneficiaries of the boom include US consumers, who are paying less for electricity, and industrial companies that use natural gas to produce everything from plastic cups to fertiliser and steel.

But these developments have been less happy for traders. Before the shale boom, the US natural gas market was much tighter and prone to sudden bursts of volatility, with spikes that exceeded $15/MMBtu in 2005 and $13/MMBtu in 2008 (see figure 1). Now, amid a protracted spell of low volatility, gas trading is a less lucrative business. In May 2012, billionaire natural gas trader John Arnold unexpectedly announced he was shutting down his Houston-based Centaurus Energy Master Fund, amid reports that the once high-flying hedge fund had hit a rough patch. Companies such as Deutsche Bank, Société Générale Corporate & Investment Banking (SG CIB) and Connecticut-based trader Freepoint Commodities have all laid off US natural gas traders in recent months, while several other major banks are also said to have culled trading teams. Figure 1 - natural gas - Energy Risk May 2013

What's more, the era of low volatility may continue for some time. In December, the EIA projected Henry Hub spot prices would stay below $4/MMBtu through 2018, measured in 2011 dollars. Chilly temperatures have driven prices slightly higher since then, with the Henry Hub spot price touching $4.18/MMBtu on April 8. Nonetheless, most analysts broadly agree with the EIA's bearish forecast. Anthony Yuen, New York-based natural gas analyst at Citi, puts the long-term price for US natural gas in the $4-5/MMBtu range. "That is still very much lower than what we saw before the shale revolution," he says. "Over the long haul, it will be cheaper than it was for much of the past decade."

It's difficult for natural gas traders to find positions, because there is less money to be made in the market

But other market observers take a different view. As manufacturers and power firms build facilities to exploit cheap gas, demand is growing rapidly, they note. Moreover, the US could begin exporting liquefied natural gas (LNG) from the Gulf Coast as soon as 2015, following a decision by the US Department of Energy (DOE) to grant an export license to Houston-based Cheniere Energy last year. When that rising demand catches up with supply, market participants should brace for a revival of volatility, some experts warn. "That supply-demand intersection is when life gets interesting," says Michelle Foss, chief energy economist at the Bureau of Economic Geology of the University of Texas at Austin. "It can happen in a surprising way. And if you have a complication - a bottleneck in a critical part of the system – then you have a much greater chance of a price event that could surprise people."

Entering the renaissance

The shale boom has inspired dozens of companies to unveil blueprints for new or expanded facilities designed to take advantage of cheap gas - a development some market commentators have termed an "industrial renaissance". A diverse array of companies have joined the rush, including steel makers such as North Carolina-based Nucor, fertiliser producers like Illinois-based CF Industries, and petrochemicals companies such as Michigan-based Dow Chemical.

"The shale revolution is triggering an avalanche of industrial capacity expansions," analysts at Barclays said in a research note in December. The bank's analysts estimated the new facilities would add 1.15 billion cubic feet per day (bcf/d) to industrial gas demand between 2013 and 2015 - representing a 6% increase from current levels of US industrial gas consumption, according to EIA data.

Accompanying the rise in industrial demand, more natural gas is being burned for electricity generation, as shale gas becomes an increasingly attractive alternative to coal. In 2000, the share of total US power generation that came from burning natural gas was 16%, but by 2010 that had risen to 24%, according to the EIA. That trend is expected to accelerate as new rules from the US Environmental Protection Agency (EPA) force the retirement of older coal-fired plants. Most notably, power companies have until April 2015 – with a potential one-year extension – to comply with the EPA's Mercury and Air Toxics Standards (Mats). The rules, which limit emissions of mercury, arsenic and other toxins by power generators, were finalised by the agency in December 2011, despite fierce opposition from the electricity industry, which considers them overly expensive. The Mats deadline is widely expected to trigger a wave of coal plant retirements, as well as a corresponding surge in gas consumption, over the next three years.

The coal-to-gas shift has broad implications. As natural gas replaces coal as the favoured fuel of US power companies, they are increasingly using it for base-load power. In other words, rather than burning gas intermittently at peaking power plants during times of high power demand, generators are now more likely to burn it day in and day out. In general, analysts say that makes prices less sensitive to demand: "Year-on-year, there are structural shifts in the power sector that make gas demand less and less reactive to prices and just more base load," says Laurent Key, New York-based natural gas analyst at SG CIB.

LNG exports are also expected to boost demand for shale gas, providing another fillip to prices. Cheniere Energy, which received a green light to export LNG from the DOE but is still in the midst of a separate approval process with the US Federal Energy Regulatory Commission, expects its Louisiana-based liquefaction facility to come online in the fourth quarter of 2015. More than 20 other companies have submitted LNG export applications to the DOE.

The impact of LNG exports on the US natural gas market is currently the subject of fierce debate. In December, a long-awaited study commissioned by the DOE concluded that LNG exports, under the most extreme scenario, would cause prices to rise by $1.09/MMBtu after five years. But the study, which was carried out by New York-based Nera Economic Consulting, said the most likely impact on prices would be far more modest. Nera's study has since been attacked by companies including Dow Chemical, which argues LNG exports will lead to much steeper price increases. The chemicals giant, along with Nucor and several other US manufacturers hoping to take advantage of cheap shale gas, have formed a coalition to lobby US government officials against allowing further LNG exports.

A volatile mix

Elsewhere, natural gas is still being used for more conventional applications, such as residential heating, which are highly responsive to the weather. The layering of this weather-driven demand on top of the increased use of gas for base-load generation can be a volatile mix. On January 25, for instance, a brutal cold snap drove the day-ahead spot price for natural gas in New England to $34.25/MMBtu, according to the EIA – the highest level since January 2004. The spike was due to the region's heavy reliance on natural gas for power generation, combined with a shortage of pipeline capacity, say analysts. SG CIB's Key believes that event could be a harbinger of things to come. "Because of these base-load demand increases, we're going to have some very tight markets in the winter now," he predicts.

That could be good news for natural gas traders, who say trading spreads between Henry Hub and other delivery locations is one of the few areas of the market where opportunities continue to abound (see box).

"As you move through the decade you've got growing gas demand from power, you've got growing gas demand from industrials, and you've got growing gas demand from LNG exports," says Samuel Andrus, North Carolina-based director of the North American natural gas group at energy consultancy IHS Cera.

While US producers have ramped up their gas output in the past few years, some analysts doubt whether this can be sustained over a longer-term period. From 56.5 bcf/d in 2009, US domestic natural gas production soared to 65.7 bcf/d in 2012, according to EIA data. But there are signs that drilling is slowing down, with rig counts declining over recent months in response to low prices. And that could lead to a return of tighter and more volatile markets, says Key at SG CIB. "We don't really think that producers are going to be able to increase supplies at the rate that they did between 2009 and 2011," he says. Heightened volatility could return as soon as November or December of this year, if the next US winter brings the usual low temperatures, he predicts.

Foss of the University of Texas agrees, saying volatility might return sooner than many market participants expect. "There are lots of things in the mix that could make 2014 and 2015 interesting," she attests.

As well as potentially boosting trading profits, the return of volatility could also be good news for banks undertaking hedging activity on behalf of clients. Market players say the past two years have seen little hedging from gas producers or consumers, since producers do not want to lock in rock-bottom prices and consumers have come to expect an extended period of cheap gas. "Utilities have been burned over the past four years by their hedging programmes," notes Ruben Moreno, a consultant with Massachusetts-based Concentric Energy Advisors. "They locked in prices at a time when gas prices were higher, so now they're paying 30% to 60% in excess of market settlement. So it's not surprising that they are a little cautious about hedging right now."

Foss at the University of Texas believes such complacency is dangerous and warns users of natural gas to remain on guard. "I've heard people suggest customers could be shocked that prices could move as strongly as they could," she says. "[But] a surprise is a possibility."


Back to basis

Even in the current low-volatility environment, some natural gas traders see opportunities. One of them is Bill Perkins, founder of Skylar Capital Management, a Houston-based natural gas hedge fund with more than $100 million in assets. “There is a lot of opportunity in the market,” says Perkins, a former trader at the Centaurus Energy Master Fund, who started Skylar last year after the fund closed down. “I think our market has a significant amount of edge for the participants on my side.”

One area where Perkins hopes to expand is basis trading – in other words, trading the spread between natural gas prices at different delivery locations throughout the US. A January 25 price spike in New England illustrates the type of volatility that a basis trader can capitalise on. “For a northeast basis trader or somebody trading in that region, the volatility is probably at a four- or five-year high,” Perkins says. “It all boils down to supply and demand, and essentially, that market is not oversupplied in the winter.”

Theoretically, a firm attempting to profit from price spikes in the northeastern US could take a long position in Transco Zone 6 Natural Gas Basis Futures, which are traded on Chicago-based CME Group’s Nymex exchange and its electronic platform, CME Globex. The contracts reflect the differential between spot prices in the area around New York and those at the Henry Hub delivery point in Louisiana.

Laurent Key, New York-based natural gas analyst at Société Générale Corporate & Investment Banking, agrees. While natural gas traders previously focused more on the liquid Henry Hub futures traded on Nymex, he believes they will be drawn more towards basis trading in the future. “There are opportunities on the basis side,” he says, suggesting that non-physical market participants such as asset managers could become increasingly attracted to trading basis spreads.

The continued attractiveness of basis trading also appears to be borne out in the job market. Amid a glum outlook for many US natural gas traders, Peter Henry, New York-based head of front-office search at recruitment firm Commodity Search Partners, says basis traders are in a better position than most. “Natural gas basis trading is one of the things that’s still in demand," he says.

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