Energy Update - Part II: Winter on the Horizon
By Frank Barbera CMT. October 16, 2007
Tension rises on the border of Iraq between Turkish Troops and Kurdish rebel. -- A severe storm system moves in to the Mid West area with Tornado Alerts posted in the Chicago area, and for a wide swath of Illinois and Wisconsin. -- In the Gulf of Mexico, a severe storm system increases jitters, as it closes in on New Orleans and Mobile, sending Natural Gas prices higher, and then lower. A month ago, few were watching the Turkish–Iraqi border, and two days ago, both Chicago and New Orleans were enjoying warm temperatures and clear sailing on the weather front. Trading commodities can drive anyone crazy, as literally the trend and direction can change overnight on the release of news headline, or a sudden change in the weather. In commodities trading, being long the market for 20 minutes can be a long-term trade with the use of stop limits an essential tool of the trade. Supply and Demand figures can also be dangerously misleading as what looks like a market burdened with a hefty oversupply can end up shifting into a bull move on the back of a serious change in the prevailing weather patterns. At the moment, as can be seen in the chart below put forth by the EIA, Natural Gas is near the high end of its level with regard to underground storage levels.
Gas in Underground Storage Compared with 5-Year Range
Source: EIA (Energy Information Administration) www.eia.doe.gov
On the surface, the unusually warm weather seen so far this year has put Natural Gas in a potentially vulnerable position. To get the gas price really moving, there can be no doubt that we will need to see a lot of cold weather as the US enters the winter months. Is it impossible for prices to move higher given the current levels of underground storage? The answer to that will normally reside in whether or not there is any type of unusual shift in the jet stream and weather patterns like El Nino and La Nina. In the case of the current winter, the forecast is for a mild La Nina event, which translates into odds of this winter yielding slightly warmer than normal temperatures versus the 30 year average. Back in 2002, with storage levels at roughly the same levels we see today, a strong El Nino pattern ended up producing a lot of severe winter weather pushing up the price of Natural Gas. In the chart below, we have placed a dashed vertical line on the storage levels as of November 1st, 2002, heading into what turned out to be a severe winter which pushed Natural Gas prices from just under $4.00 to just over $7.00.
Source: EIA (Energy Information Administration) www.eia.doe.gov
According to a just released study from NOAA (National Oceanic and Atmospheric Association), within the Northeast, Mid-Atlantic temperatures are expected to be ”above average in response to the long-term warming trend. Snowfall for the region will depend on other climate factors, which are difficult to anticipate more than one-to-two weeks in advance.“ Still, the price action in Natural Gas continues to act favorably, even in the wake of what otherwise appears to be a disappointing forecast where Natural Gas commodity bulls are concerned. Over the last few weeks, the Chicago Commitment of Traders Report has been extremely skewed. During that time, we have noted a huge surge in buying from Commercial Interests, while at the same time, Large Speculators have moved to an extreme position Net Short. Historically, netting the two has seen excess commercial buying carrying the day on nearly every occasion, and to that end, one wonders what is driving the commercials to such a strong long position.
Turning to the Weekly Chart for Natural Gas, we also continue to see a positive technical set up with a potential bullish divergence present on the chart of MACD. On the daily chart, the price action seen thus far in 2007 has been one of a very wide trading range with support coming in at $5.70 and resistance at $8.25 to $8.30. In our view, unless we start to see very cold weather fairly soon, between now and Thanksgiving, the excess supply in Natural gas could mean that will be difficult for Nat Gas to press through the upper end of the range at $8.25, which would be needed to kick start a truly large advance. In July of 2007, we pointed out the extreme undervaluation of Natural Gas and the new ETF, UNG, which is a good way to purchase Nat Gas as a longer-term investment. To be sure, looking out over the next few years, it is very likely that declining production of Natural Gas will force prices a lot higher. However, for most investors, the 4 to 6 month view is key, and on that basis we would be inclined to stick with Natural Gas a little while longer and see how the weather shapes up over the next few weeks. If things begin to look like they are not going to shape up well for cold weather this winter, then it may be better to shift focus to other areas of the energy patch.
While current stockpiles are high for Natural Gas, Heating Oil supplies are already very low, by about 13 million barrels versus this time last year, and are already below the five-year average. Current forecasts suggest that if winter is 10% colder than expected, odds will be high that the price of Heating Oil could move sharply higher. That could be good news for some of the country's refining companies, where the Crude Oil to Refined Product spreads, the so-called ‘Crack Spread,’ has been weak over the last few months. Over the last few days, we have seen Heating Oil prices already breaking out to the upside, in the process helping to push our Winter Fuels Index (Natural Gas and Heating Oil ) to new highs for 2007.
Above: Heating Oil follows Crude to new all time highs.
Above: The Winter Fuel Composite, Unweighted Index is also moving higher combining Natural Gas with Heating Oil.
With the strength in Heating Oil, and the end of the weak ‘shoulder’ season for Crude, switching from Gasoline production to Distillate production, there is a good chance that the Crack Spread will begin to improve as winter approaches, even a more modest winter. Historically, this spread between Crude Oil and its distillate products (gasoline and heating oil) has been low near $10 and high near $20. In recent years, there have been disruptions and refining shortages which have led the spread to widen toward $40. While it is down from its absolute highs, at near $20, the spread is still very profitable for refiners. In addition, we have constructed a simple oscillator which plots the current Crack Spread versus its one year moving average. At the moment, that oscillator is extremely oversold suggesting that the Crack Spread may be in a zone where it will once again begin to widen. There are several big names within the Refining Sector, with Valero Energy (VLO), Marathon Oil (MRO) and Tesoro Petroleum (TSO) the most widely followed. All of these companies are highly leveraged to changes in the Crack Spread and all are still below their 52 week highs. In addition, the entire refining group is also trading at low Price-Earnings Multiples, and low Price Earnings to Growth Ratios, ‘P/E’ and ‘PEG’ multiples. (VLO - P/E at 8.72 PEG at .50, MRO -P/E at 9.17 PEG at .87, and TSO- P/E at 8.91 PEG at .64.)
Finally, in addition to the Oil Refiners, one other name really stands out getting back to the original theme of Natural Gas. If the commodity does run into tough going on the upside as the result of a relatively modest winter, among the big name Natural Gas producers, Chesapeake Energy (CHK) is a name that could potentially play catch up. In most instances, these large cap Natural Gas stocks such as Devon Energy (DVN), Anadarko Petroleum (APC) and Apache Corp (APA) have all been on a steady march to new all time highs. Chesapeake Energy, which has an equally robust growth profile has been held back due to a string of acquisitions, which have increased the share float and long term debt. However, the company appears to be done consolidating, and is now focused on maximizing its cash flow from existing properties. CHK is currently at 11.98 times current earnings, with a PEG of .48.
Above: Apache Corp (APA-upper), Devon Energy (DVN-upper) Anadarko Petroleum (APC -middle), and very bottom Chesapeake Energy (CHK).
Be aware that none of the above should be taken as specific stock recommendations. In all cases, investors are strongly cautioned to do their own homework, as we merely seek to point out some of the more interesting anomalies which are present in the energy market, and in the world of energy stocks.
At the close, the stock market indices ended lower with the DJIA down 71.86 index points to finish at 13912.94, with the S&P 500 down 10.18 index points at 1538.53, and the NASDAQ Composite down 15.74 index points at 2764.31. The 10 year Treasury Bond finished at a yield of 4.66% with nearby December Gold ending up +2.30 to close at $764.50. That's all for now,
© 2007 Frank Barbera