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Economics: Heat Wave
New York: August 07, 2006
By John R. Stephenson

Lately it's been hot — really hot. With temperatures on the rise, air conditioners across North America have been working overtime. It's not just the air conditioners and fans that have been getting a workout these days, the nation's electricity system has been straining under the demand. The strong demand for electricity to power air conditioners to deal with this prolonged stretch of high heat and humidity has illustrated just how strained the nation's electricity system is. With strong demand and struggling supply, every generator capable of producing a kilowatt of electricity has been put into service.

But the news isn't all bad — natural gas prices have come out of the basement lately as strong demand for electricity has resulted in more and more natural gas-fired electricity generators working overtime to meet the demand. The result? Natural gas prices have moved from $5.73/MMBTU (10,000 million British Thermal Units) on July 7th to close on Friday at $7.246 —a gain of 26.45 percent. While this has been good news for commodity traders who have been betting on resurgent natural gas prices, it is also good news for small oil and gas exploration and production companies whose shares have languished recently.

Figure 1: Natural Gas Prices

Source: First Asset Investment Management Inc.


But while natural gas traders have spent the last six months focusing on the amount of natural gas in storage, they seem to have been oblivious to the pink elephant in the room — weather. Historically, natural gas prices have tended to peak during the wintertime when demand for natural gas for heating as well as electricity generation is at its maximum. Not so anymore. Iincreasingly, air conditioning and the tremendous load that it puts on the nation's electricity system has become the SUVs of the natural gas world. With extreme temperatures seemingly the norm, the call on natural gas is likely to grow stronger, not fainter, in the months to come.

Natural gas is used for both heating, electricity generation and as a raw material for certain chemical and manufacturing processes. But of these uses, heating and electricity generation are by far the lion's share. What that means is that, as a commodity, natural gas prices are incredibly weather dependent. In fact, 84 percent of the price movement of natural gas is temperature related.

Figure 2: Gulf of Mexico Surface Temperatures and Hurricane Intensity

Not only are high temperatures uncomfortable, but in many cases, they can be the cause of something far more worrisome — hurricanes. With surface temperatures in the Gulf of Mexico some 3 percent warmer than last year, the likelihood of a prolonged period of severe weather in the Gulf Coast region is a very real possibility. Currently, there are no offshore oil and gas rigs that are capable of withstanding a direct hit from a category four or five hurricane. With most of the growth in domestic natural gas production coming from the Gulf region, a possible "perfect storm" for natural gas and electricity prices may be brewing.

But that's not all. For decades, natural gas production has been declining while demand has been growing. Some 90 percent of all electricity generation that was built between 1985 and 2001 was natural gas fired. That's because natural gas was believed to be plentiful, the plants were relatively simple to construct and were environmentally friendly. Today, the situation is different.

Like the oil fields around the world, natural gas fields have been declining with most of the producers having already picked the low hanging fruit. The new gas fields that have been identified are deeper and therefore more expensive to extract. Gas fields in the Arctic and Canada have no pipeline infrastructure to support them and are tied up in red tape and bureaucratic bungling. Natural gas in liquefied form (LNG) can be imported from abroad, but, so far, local resistance to the construction of LNG terminals has made this an unlikely solution to the problem of far too much demand and short supply.

For energy investors, this is good news. Natural gas and oil prices have historically traded at a ratio of 1:6 (i.e. if gas is $6/MMBTU oil is generally $36/barrel). Today, that ratio has been more like 1:12. This is unlikely to be sustained for very much longer. With surging temperatures creating the demand for increased electricity, natural gas prices are likely to soar in the months to come lifting the spirits of commodity traders, electricity producers and oil & gas companies alike.


StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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