Spike in natural gas prices could be short-lived

'Tis the season … the heating season that is. That means American households will now have to allocate a larger portion of their monthly budgets to the purchase of heating fuels, typically either natural gas or heating oil. And it should not surprise anybody that when demand for heating fuels rise, the prices paid for fuels also rise. We should expect a seasonal increase in the prices paid for heating fuels when the weather turns cold.

I have monitored the trends in the price charts for crude oil, heating oil, gasoline and natural gas for many years. These commodities are excellent indicators of overall economic activity and consumer spending patterns. They also provide valuable insight into how demand for many plastics products is changing and where it will likely go in the near future.

These trends are also important to processors, compounders and distributors because they impact the future trends in the prices for most plastic resins. Throughout most of the history of the data, there was a very tight relationship between the price of crude oil and the price of resins. This relationship has loosened recently due to the burgeoning use of natural gas as a raw material. And I think it is safe to conclude that the impact the natural gas industry has on the plastics industry will continue to increase in the future.

If you look closely at the chart, you can see that there is usually a small but distinct seasonal rise in the price of natural gas in the fourth quarter of each year. But, occasionally, the prices for heating fuels will spike up much higher than expected. Market analysts call this a "parabolic move," and the natural gas market is renowned for its ability to go parabolic. That's what happened in the winter of 2013-14, and it looks like it could happen again this season.

After trending sideways around the level of $3 per contract for most of the past four years — a contract is defined as the amount of gas needed to generate 1 million BTUs — the price jumped up to nearly $5 per contract last week. Some analysts predict that it could get up as high as $7 or $8 before it hits a seasonal peak.

News reports indicate this recent jump was so severe and so rapid that it bankrupted several large trading firms. And daily trading volumes for natural gas futures hit all-time highs.

Now I want to state clearly that I am not offering a forecast or even an opinion about what the price of natural gas will do in the future. It may continue to rise sharply, or this recent flurry of activity may end as quickly as it began, with prices settling back down at their long-term averages. Nevertheless, the recent volatility adds an element of risk to the outlook for the industry in the coming months. Even if we cannot predict the future, we should at least try to garner some understanding of the present.

Most of the news reports attribute the recent price spike to a spate of unusually cold weather in the southern half of the United States. This resulted in a larger-than-expected drawdown in the amount of natural gas in storage, which pushed up prices. But from my perspective, last week's jump in price was too big to be explained entirely by a November cold snap in Kansas.

A complete explanation of natural gas prices that are 30-40 percent higher than the average for this time likely includes speculators and something called a "short squeeze." My theory is that as the price for crude oil started to drop unexpectedly in October, speculators purchased crude oil contracts in anticipation the downtrend would be short-lived. To hedge some of the risk of these positions, they sold natural gas contracts. This is called a spread, and it is a strategy that will mitigate risk most of the time and under normal conditions. But sometimes it can get really ugly. You will recall that failed spread strategies in the home mortgage sector caused the financial market meltdown in 2008.

Unfortunately for last month's spread strategy in the energy sector, the price of crude oil has dropped even further, and an earlier-than-expected cold snap sparked a rally in the price of natural gas. With both sides of the spread under pressure, speculators have scrambled to get out of their positions. The result has been a further decline in oil prices and a sharp rise in gas prices.

If we learned anything from 2008, it is that these conditions can persist much longer and go much deeper than anybody thinks. This means that both confidence levels and future demand for plastics products could be constrained due to the rapidly rising price of heating fuels, and at the same time, the price of resins made from natural gas could also go higher. Risk is ever present, and we must be diligent and thorough in our risk assessment activities.

While I am aware of the downside risks of this outcome, I do not think this is the most likely of all possible future outcomes. I think the most likely scenario is that this spike in the price of natural gas is short-lived and the trend will soon revert to the average. I have even heard forecasts for this to be a warmer than average winter — remember global warming? — so the price of natural gas may fall below the long-term average in a few weeks.