As El Niño fades, will natural gas soar?

May 19, 2016 10:00 AM

The El Niño of 2015-16 tied the 1997-98 weather episode for being the strongest on record. In both cases, sea surface temperatures along the central and east-central equatorial Pacific peaked at 2.3 degrees centigrade above normal, resulting in a much warmer-than-normal winter for the northern United States and Canada. The recent spike in temperature depressed electricity and heating demand, and put natural gas prices under downward pressure this past winter just as it did in 1997 and 1998.  

The question now for the natural gas market is, “What happens next?” Just as the 1997-98 El Niño’s impact on natural gas presaged what would happen to gas prices this time around, the aftermath of the previous episode might provide some insight as to where natural gas prices might head in the near future (see “El Niño and natural gas,” below). 

Following the 1997-98 El Niño’s peak intensity in November and December 1997, natural gas prices remained depressed for all of 1998. The fact that the 1997-98 El Niño had turned into a La Niña by the end of 1998 did not immediately boost prices. The reason was fairly simple: Storage levels. Stocks of natural gas swelled during the 1997-1998 El Niño, rising by as much as half a trillion cubic feet above previous levels. It was not until 1999 and 2000 when those storage levels were drawn down to a point that natural gas prices began to soar (see “Gassing up,” below). 

Natural gas inventories have spiked once again during the current El Niño. By March 2016, storage levels were nearly one trillion cubic feet larger than they were a year earlier—a 68% year-on-year rise. This may prevent natural gas from staging a strong rally until those levels have come down. When the levels come down, however, there is a great deal of upside potential, particularly if a strong, persistent La Niña develops, as was the case after previous and similarly strong Los Niños (1972-73, 1982-83 and 1997-98).

If the world experiences a prolonged La Niña, the potential upside for natural gas prices is enormous. During the 1998-2001 La Niña, prices eventually rose close to $10 per MMBtu, a more than 500% rally from their 1997-98 El Niño lows.  However, it took a substantial drawdown in storage levels to get them up there. 

Factors to watch

There are a number of factors to watch to see how natural gas prices might move as the El Niño fades, some weather-related and some not. 

From a meteorological perspective, watch the “delta” — how quickly this El Niño fades might indicate whether it is going to turn into a La Niña. From El Niño’s peak in 1998 to the 1999-2001 one, and La Niña’s initial temperature lows in December 1999 (it became even more intense in 2000 and 2001), there was a dramatic change in sea surface temperatures. A similar phenomenon appears to be happening this time as well, but we are just a few months past the peak.   

In addition to the weather-related factors, there are numerous non-weather issues to focus on.  

  • Production: After many years of strong increases, U.S. natural gas production levels have stopped growing and have, in fact, been flat for the past nine months.
  • Investment: Rig counts for both crude oil and natural gas have collapsed, meaning little new exploration will take place in coming years. 
  • Exports: The United States has begun exporting LNG from Chenière Sabine Pass and other export facilities are in the works. 
  • Demand: The Department of Energy projects that natural gas will overtake coal this year as the chief source of electricity generation owing, in part, to the sharp increases in natural-gas generation capacity that has been coming on line (and more will continue to come on line).
  • Alternatives: Large amounts of alternative energy production capacity are also coming online, but with alternatives there are two things to remember: First, capacity is not the same thing as generation. Solar panels and wind turbines generate nothing when the sun is not shining or the wind blowing, respectively. On average, they run at about one-quarter capacity whereas natural gas generation comes close to operating at full capacity. Secondly, investment in the solar and wind sectors depends heavily on tax subsidies, and the future of such tax subsidies depends on political outcomes in Washington that are difficult to forecast. Coal, meanwhile, is natural gas’s main competitor and is in terminal decline. 

On balance, these “other” factors argue for higher natural gas prices going forward.  The exceptions are the alternative forms of energy, to the extent that solar and wind take a bite out of the demand for natural gas. Stagnating production, slumping investment and increased demand point to the possibility of a massive run up in natural gas prices like we saw in 1999-2000. 

Meanwhile, the possibility of further export growth should, at a minimum, put a floor under the price of natural gas. In the meantime, in addition to watching the traditional economic drivers of natural gas, do not forget to visit the National Oceanic and Atmospheric Administration’s (NOAA) website and check out sea surface temperature anomalies. As much as any other factor, NOAA holds the key to understanding the intermediate-term evolution of natural gas prices. 

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

About the Author

Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.