Rare U.S. Gas Phenomenon Signals Price Shocks as Glut Shrinks

(Bloomberg) -- A rare phenomenon in U.S. natural gas futures suggests traders may be in for a wild ride as a supply cushion shrinks, leaving the market at risk of price swings.

Gas for delivery this year and the next is trading at a steep premium to contracts further in the future, a condition known as backwardation. The last time the forward curve looked this way in the fall was a decade ago, when supply disruptions from hurricanes sent gas prices soaring in the era before the shale revolution unleashed a production boom.

The curve signals unusual volatility in the gas market for the next year as rising exports and diminishing output from shale basins stoke concern that output won’t be enough to prevent price shocks in the winter, the peak season for heating demand. Backwardation emerged in June and has become more pronounced after government estimates showed U.S. gas supply will drop in 2016 for the first time in 11 years.

“When we have in gas a backwardation, it’s a unique development,” said Francisco Blanch, head of global commodities and derivatives research at Bank of America Corp. in New York. “The market is asking for producers to increase supply. You might get some spikey price behavior.”

The upcoming winter will be “more susceptible” to those price spikes, potentially sending gas to $4 to $5 per million British thermal units depending on how cold it gets, he said. Blanch sees gas averaging $3.50 in 2017 to encourage more production.

Futures for 2016 delivery in January and February, the months when heating demand for natural gas is highest, are trading near $3.50 on the New York Mercantile Exchange versus an average of $2.41 so far this year for front-month futures. Futures for 2018 were recently valued at $3.09, according to Bloomberg Fair Value prices.

Trading Jumps

Trading is also starting to rebound. Aggregate open interest for Nymex gas futures jumped this month to the highest since March 2014. The volume of electronically traded futures, along with the 30- and 50-day volatility for the front-month contracts, all jumped this month to the most for any October since 2012.

“There is a lot of fear being priced into the futures curve,” said Stephen Schork, president of Schork Group Inc., a consulting group in Villanova, Pennsylvania. After last year’s mild winter, “any sort of return to a normal winter means demand is going to be extraordinarily strong.”

This December through February may be be 20 percent colder than the same period a year earlier, Jason Setree, a meteorologist with Commodity Weather Group LLC in Bethesda, Maryland, said in e-mail Friday. And the effect of frigid weather may be magnified as coal plants are retired, sending gas consumption by power generators to a record. 

Driller Response

Drillers may already be starting to respond to higher prices. Futures for 2018 and 2019 are trading below near-term contracts because producers have been locking in contracts to hedge their output for that period, Blanch said.

Still, a stockpile glut that ballooned to more than 50 percent above the five-year average in April almost been wiped out. While supplies are approaching an all-time high, the amount of gas that’s flowed into storage caverns ahead of the winter has been about a third lower than normal.

“We might have a strong absolute value of storage, but the direction of injections here lately is what brings on emotion,” Brian Swan, commodity analyst at Schneider Electric in Louisville, Kentucky, said in an e-mail Thursday. “The fear of the ‘what if’ is still in the back of the trader’s mind.”

To contact the reporter on this story: Naureen S. Malik in New York at nmalik28@bloomberg.net. To contact the editors responsible for this story: Lynn Doan at ldoan6@bloomberg.net, Christine Buurma