Author: Asset Investment Management

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Even though the US experienced one of the coldest winter heating seasons in (2013/14) many years, the spot Natural Gas or Nat Gas for short, futures price did not increase to anywhere near the levels it did during previous very cold winters nor did volatility go through the roof. The main reason for this significant change in price activity is the surge in US production of Nat Gas from several very large shale gas producing regions of the country. That said, Nat Gas price activity remains a function of supply and demand. Although futures prices have not returned to the double digit levels seen in the pre-revolution years, prices did hit the highest level this past winter since the winter of 2009.

The major change in the Nat Gas market over the last several years is primarily on the supply side of the equation. Demand has been growing slowly with the occasional demand surge due to weather as we saw in the winter of 2013/14. The Nat Gas futures contract traded on NYMEX is principally a US produced and consumed commodity. Some Nat Gas flows from Canada and some gas flows to Mexico but as of now the LNG market is still not a factor in either flow direction.

The demand side of the equation is impacted by the economy. As the US economy moves into a sustainable growth pattern, the use of Nat Gas will likely continue to increase in the industrial and commercial sector. With the abundance of Nat Gas due to the shale revolution and relatively low prices versus many other places in the world, there has been a manufacturing advantage for those sectors using Nat Gas in their manufacturing operation. Although this is a growth area for Nat Gas, it will not result in a surge in demand in the short to medium term, rather, it is a slow and steady growth area.

Utilities may burn more or less Nat Gas depending on prices between oil, coal and Nat Gas. Many utilities have the capability of switching between Nat Gas and coal based on the most economical fuel at the time. Since the second half of 2012 the majority of the time coal has been more economical than Nat Gas for power generation. To the extent that a utility has the capability to burn coal it was likely their preference for the last several years. This pattern is likely to continue in the medium term especially with Nat Gas inventories still well below normal after the cold winter of 2013/14 (and prices higher than the last few years). Over the long term the EPA has placed additional regulations on coal driven power plants which will result in less coal and additional Nat Gas consumed for power generation.

Thus the main incremental use for Nat Gas in the US is for meeting heating and cooling needs and will remain in this pattern for the foreseeable future. A larger percentage of Nat Gas is consumed during the winter heating season with a portion of the consumption during the summer cooling season to supplement utility demand of air conditioning.

Nat Gas futures prices are generally driven by the short term weather forecasts produced by NOAA (free) and many private forecasters (fee based service).

Following is the latest actual and forecasted demand for Nat Gas produced by the EIA shown on a quarterly basis. The table shows the seasonal demand for Nat Gas during the winter and simmer seasons and is highlighted in red.

Nat Gas Consumption US (EIA Data), BCF/Day
	2014				2015
	Q1	Q2	Q3	Q4	Q1	Q2	Q3	Q4
Residential	28.86	7.09	3.55	15.5	24.3	7.1	3.68	15.8
Commercial	16.55	5.75	4.33	10.2	13.8	5.8	4.35	10.4
Industrial	23	19.8	19.5	22	23.2	20.6	20.3	22.6
Electric Power	19.79	20.9	28.4	19.9	20.4	22.2	29.2	20.7
Lease and Plant Fuel	3.95	3.98	4	4.02	4.05	4.06	4.06	4.08
Pipeline & Distribution Use	2.68	1.75	1.75	2.01	2.49	1.78	1.76	2.03
Vehicle Use	0.09	0.09	0.09	0.09	0.09	0.09	0.09	0.09
Total Consumption	94.93	59.4	61.6	73.6	88.3	61.6	63.4	75.7

Source Data: U.S. Energy Information Administration Data

Moving over to the supply side of the equation, the shale revolution has had a significant impact on the overall performance of Nat Gas prices as well as the volatility of this contract. The following chart from the most recent EIA Short Term Energy Outlook report (issued monthly) shows the steady growth in supply over the last several years.

Nat Gas production has steadily grown over the last several years adding a needed cushion to cover unscheduled issues as well as seasonal demand surges along with diversifying the supply profile in the US. The US is now less dependent on Nat Gas from the Gulf of Mexico (still a very important supply source) as all of the new production gains have been on-shore and out of harm’s way of hurricanes that often times find their way in the Gulf of Mexico and disrupt supply lines from that region. The projected supply growth should act to dampen any severe seasonal weather occurrences going forward.

That said, there is still a large variation in the inventory profile for Nat Gas. The following chart shows the normal seasonal movement in Nat Gas and how low inventories occurred after the severe winter of 2013/14.

Source Data: U.S. Energy Information Administration Historical Data

The recovery of inventories heading into the winter of 2014/15 should have a strong impact on price activity during the summer cooling season as well as during the upcoming winter heating season. Weekly inventory levels have demonstrated a quick and strong impact on price activity.

As an example, with inventories below normal in 2014 so far the market has been maintaining a modest and widening price risk premium compared to 2013. The premium has been averaged about $0.485/mmbtu above 2013 since the beginning of April into early June.

This premium is a risk premium of starting the winter heating season with a gap in inventories. The widening premium suggests that the market is starting to take a stand that the projected gap in inventories ahead of the upcoming winter is likely to be the dominant price driver in the near to medium term. The premium may gain momentum at this point in time as the industry seems less relaxed that the recent pattern of above normal injections over the last several weeks will continue throughout the season.

Nat Gas trading is very dependent on supply and demand fundamentals with the supply side of the equation resulting in the most significant change in the structure of the Nat Gas market since it was deregulated in 1990 (also when the NYMEX Nat Gas contract came in to existence).

If you have any questions send a message or contact me

Regards,
Peter Knight Advisor

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Relationships between Crude Oil, Heating Oil and Gasoline

Even though the US economy is still a gasoline driven economy, the HO crack spread has become more and more interesting from a trading perspective as the US is now a major exporter of distillate fuels – HO and diesel. Like the Brent/WTI spread, the HO crack spread is very liquid as well as volatile and trendy – all positives for the trading community at all levels. In addition this spread is also used by the refiners as a hedge during periods when refinery margins are expected to narrow.

It is also a spread that can be traded on the NYMEX division of CME as part of the regulated futures arena. Volumetric activity for the spread is continuing to grow, as is liquidity.

This is a very fundamentally driven spread (as are most spreads) with the same fundamentals driving the direction of the spread for many years. The main fundamental drivers of the spread are:

Winter month demand for heating oil in the US and in Europe.

Inventory levels of heating oil and diesel.

Throughout the year the growing demand for diesel fuel in many regions of the world that are now exports targets for US refiners.

The state of the gasoline market in the US.

Crude oil balances and geopolitics and the impact it has on refiner’s crude oil costs.

Other weather events like hurricanes.

Scheduled and unscheduled refinery interruptions.

First let’s quickly discuss what the HO crack spread is and is not. It is not an absolute measure of refinery margins in the US as the HO portion is a wholesale price in New York Harbor as traded on the NYMEX division of CME while the WTI crude oil is price is a spot prices based in Cushing, Oklahoma. It does not include any refinery costs or location adjustments. It is a gross representation of the direction of the distillate component of refinery margins against WTI crude oil – one of the many, many crude oils that the US refiners actually process in their refineries. Simply put, when the HO crack spread is trending higher it means refiners are making more money processing crude oil to make distillate fuel and when the spread is trending lower they are making less money.

With this in mind, the following chart shows the NYMEX HO crack spread plotted on a seasonal chart along with the latest five year average and the highs and lows that occurred when the calculations for the five year period performed.

Source: NYMEX ULSD Historical Data

This is what is categorized as an inter-market spread with reduced trading margins compared to trading the flat price for either of these commodities. This weekly chart clearly shows a modest level of volatility as well as the trending nature of this spread. It also shows the seasonality of the spread with the high points generally hit during the so called official winter heating season (October through March) with the lows generally occurring during the summer months or during the gasoline driving season.

Certainly during the heating season the direction of the spread is going to be primarily driven by the winter weather and thus heating demand for heating fuels in both the US and Europe. During the heating season oil will flow between these two regions depending on the weather and demand for heating oil in each of the respective areas.

In the US the majority of the heating oil consumed for space heating is in the Northeast with minimal quantities consumed in other regions of the US. Thus when evaluating the spread during the winter months, the weather along the northeast coast is important. Also keep in mind New York, which represents almost 1/3 of the Northeast heating oil market, now requires ultra-low sulfur fuel (15 PPM) as reported by the U.S. Energy Information.

The following chart compares the spot NYMEXHO Crack spread with the weekly HO inventories along the East Coast of the US – the primary HO market in the US.

Source: Chart provided by DTN

As shown on the chart, there is a relatively strong inverse correlation between HO inventory levels along the east coast with the performance of the HO crack spread. As HO inventories rise the crack narrows and when stocks decline the crack has a tendency to widen. As expected the strongest correlations tend to be during the so called official winter heating season.

In addition the temperatures forecasts for Europe are also very important. These forecasts do impact the short term direction of the spread and add to the volatility of the crack spread in the short to medium term.

Another area that has an impact on the HO crack spread is the supply and demand status of the gasoline market. Refiners have a lot of flexibility to maximize the production of gasoline at the expense of distillate fuel and vice versa. When gasoline demand is strong and/or supply is tight refiners will run in a maximum gasoline mode which will reduce the amount of distillate fuel produced. This could result in distillate fuel inventories declining and thus having a positive or upside impact on the HO crack spread.

In addition during periods of tightness in the crude oil markets caused by rising demand and/or supply issues due to natural events like hurricanes or geopolitical events like seen for many years in the Middle East and in North Africa the price of crude oil (the other half of the spread) could surge higher and have a negative impact on the HO crack spread even during periods when the relationships discussed above comparing inventories and the spread support a widening of the spread.

Finally, scheduled and unscheduled refinery events can impact the spread in either direction. When refineries are shut down for whatever reason it has an impact on production of distillate fuel (as well as all refined products) and often times result in a widening of the HO crack spread. On the other hand, when refinery runs are at high levels, more refined product is produced which could ultimately result in a narrowing of the crack spreads.

The following chart of the refinery run rates along the US East Coast (main heating oil market) versus the HO Crack spread demonstrate this relationship.

Source: Chart provided by DTN

The chart shows an inverse relationship between refinery run rates and the crack spread. Although this is not a perfect correlation it holds most of the time. When the refinery runs rates are increasing it generally has a negative impact on the HO crack spread and vice versa.

The above are the main price drivers of the spread.

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Discovering Trading Opportunities with Two Benchmarks

The single most widely traded spread in the global oil complex is the WTI/Brent spread and the change in the relationships between these two global marker crude oils has implications to both crude oil and refined products on a global basis. It is also the most important spread in setting all of the various pricing interrelationships among the many different crude oil grades as well as for refined products inside and outside the US. Brent (North Sea crude oil) and WTI (US indigenous crude oil) are the industry’s two main benchmark crude oils which the majority all of the crude oils around the world are priced against.

This spread is not only traded heavily by the speculative community, it is also traded by the oil industry asset trading sector or those that actually are responsible for all of the physical crude oil acquisitions around the world. It is also a spread that can be traded on NYMEX as part of the regulated futures arena, as well as the cleared over the counter system on CME Direct. Volumetric activity for the spread is continuing to grow, as is liquidity with relatively narrow bid/offer ranges.

Although the spread does respond well to various technical analysis techniques, this is a very fundamentally driven spread with the same fundamentals driving the direction of the spread for many years. The main fundamental drivers of the spread are:

US crude oil production levels

Crude oil supply and demand balance in the US – i.e. crude oil inventory position in Cushing, PADD 2(mid-west) and PADD 3 (Gulf region)

North Sea crude oil operations

Geopolitical issues in the International crude oil market

There are other minor fundamental drivers but the aforementioned list of drivers is the focus of this paper. Understanding the aforementioned spread directional drivers may provide decent signals when trading this spread.

There has been a major transition that has taken place in the US and Canadian crude oil markets that has had a major impact on the direction of the spread since about 2008. The US crude oil revolution has resulted in a significant increase in US domestic crude oil production as a result of the successful technologies applied to the main shale oil regions of the US – i.e. Bakken, Permian, Eagle Ford, Niobrara, Haynesville and Marcellus. The drilling and production success in these regions coupled with a significant increase in the availability of Canadian crude oil for the US has significantly changed the dynamics of the US oil industry.

The US logistics system was designed and built as a south to north pipeline system. This system was designed around the large crude oil reserves and production level in the Gulf region (in particular Texas) of the US as well as the large volume of imported crude oil that entered to the US to supplement US indigenous production for the main refinery centers in the Gulf and PADD 2 region (mid-west). The west coast has mostly consumed California and Alaskan crude oil and supplemented by imports while the east coast refining system has been dependent on offshore imports.

With a significant increase in US domestic crude oil production and a surge in Canadian imports the south to north logistics system created a huge bottleneck in the Cushing area (also the delivery location for the NYMEX WTI contract). Cushing stocks built strongly as the intake capacity to Cushing far exceed the takeaway pipeline capacity. This resulted in a huge overhang of crude oil and thus had a very depressing impact on the price of WTI, especially relative to Brent.

Over the last two years the mid-stream industry has done a fantastic job in increasing the crude oil takeaway capacity out of Cushing by building new pipelines and reversing several south-to-north pipelines that were no longer needed. In addition rails deliveries of crude oil from Canada and North Dakota have also played a large role in adjusting the logistics system to accommodate the oil shale revolution taking place.

Cushing stocks are now back down to the level they were at prior to the onset of the surge in crude oil supplies from the US and Canada. In fact Cushing is now a transition area feeding both the PADD 2 and PADD 3 regions. Crude oil coming into Cushing supplies a combination of PADD 2 refineries that are connected to Cushing via pipeline as well as sending crude oil down to the Gulf Coast refineries. There should not be a large build up in crude oil in the Cushing region unless the market moves into a strong contango and economics justify building crude oil facilities. Inventory levels in Cushing will find a normal operating level needed by the PADD 2 refiners.

In regard to the main drivers, US crude oil production and imports from Canada are projected to continue and grow well into the future. This trend will support the main changes that have taken place in the logistics system and most importantly in the crude oil acquisition pattern for the US refining system which brings me to the main directional driver… Cushing crude oil stocks.

The following chart shows the relatively strong correlation between inventory levels in Cushing and the WTI/Brent spread. This is a weekly chart to coincide with the weekly release of EIA Cushing inventory data.

Source: Charts provided by DTN

In spite of the major transition that has taken place in the slate of crude oil for the US refining system as well as the in the logistics system the correlation between the direction of Cushing inventories and the spread remain solidly in place.

Over the last several years as the logistics have changed the relationship between PADD 3 (Gulf region) crude oil stocks are also starting to be a reasonably correlated directional driver of the WTI/Brent spread as shown in the following chart.

Source: Charts provided by DTN

With Cushing crude oil stocks now back to the pre-surplus normal operating range level and with Cushing acting more as a transition areas between PADD 2 and PADD 3 the relationship of PADD 3 inventories are also now driving the spread.

On the other end of the spread (Brent side) the two main general areas that have an impact on the spread is production levels of crude oil from the North Sea. From time to time severe weather impacts the flow of crude oil out of the North Sea. During periods of time when flow is impeded it has a tendency of strengthening the Brent side of the spread irrespective of what is going on in the US. In addition when there are geopolitical interruptions in the flow of crude oil from various locations (i.e. Libya, Nigeria, Middle East, etc.) it has a stronger impact (generally upside) on the Brent side of the spread and has a tendency to offset any bearish spread signals coming from the US side of the spread.

There are three sources of inventory data that are released at different times of the week. Genscape reports Cushing crude oil stocks at 9 AM on Monday. This is a subscription service. The subscribers of this report certainly set their positions in the WTI/Brent spread if a signal presents itself. The API issues its Cushing inventory data late on Tuesday afternoons – also for a subscription fee. However, this data tends to be broadcast via several news services and on Twitter. Finally the most comprehensive and free inventory data is released mid-morning on Wednesday by the EIA. All of these data sources are in close agreement for Cushing crude oil inventories. Finally the inventory data points are always as of the previous Friday.

The above are the main price drivers of the spread.

This spread has a high level of liquidity to allow for relatively easy entry and exit as well as a high level of volatility. Furthermore as you can see from the charts presented in the paper the spread tends to trend for extended periods of time allowing for many entry and exit points during the course of a trend.