As we head into the fall of 2015, it appears that a strong El Niño is forming in the Pacific Ocean that may rival the one that occurred through 1997 and 1998 and had significant consequences for the natural gas market in North America.
El Niño is a macro-scale weather phenomenon associated with warmer-than-average sea surface temperatures across the Central and East-Central Equatorial Pacific. This weather anomaly typically increases temperatures over Western and Central Canada and over the Western and Northern United States and creates cool and wet conditions in Florida and the Gulf Coast. After a period of warmer equatorial waters in the Pacific, we often see cooler than usual waters, known as La Niña. Not surprisingly, La Niña has largely the opposite effects of El Niño, bringing cooler temperatures to much of North America. Both El Niño and La Niña usually begin between March and June and reach their peak intensity between November and February. (Figure 1)
The data make clear that El Niño and La Niña are not the primary drivers of natural gas prices over long periods of time.The natural gas market is highly inelastic on both the supply and demand sides, making prices very responsive to short-term changes in fundamental drivers including production, storage levels, and weather. The natural gas term structure is defined by cyclicality, which is due to seasonal consumption related to the residential and industrial sectors as well as to electrical generation. Unexpected changes in the fundamental factors can create supply-demand imbalance, high volatility, and price shocks.
In this article we present evidence that El Niño and La Niña have consequences for Henry Hub Natural Gas futures prices –but not always the impacts that one might expect. El Niño events vary in duration and magnitude. In the 1997-1998 heating season, the US experienced the largest El Niño event on record and the second warmest winter since detailed records began in 1895, which led to warmer-than-average temperatures in the Northern US and colder-than-average temperatures in the South. More moderate-than-normal temperatures created high inventory levels and a supply glut in natural gas. As indicated in Figure 2, after climbing during the summer and early fall of 1997, Henry Hub futures prices declined to a low of $1.65 by the summer of 1998. During the winter season, gas prices averaged $1.92. This level was 20 to 25% below the seasonal norms.
By mid-1998, Equatorial Pacific Ocean temperatures had cooled down, creating a La Niña weather pattern that continued through the winters of 1998-1999 and 1999-2000. During these two heating seasons, the Northeast region, which is a major demand market, experienced below average temperatures and consumed more gas than previous winter seasons. Natural gas prices recovered in late 1998 and 1999 before soaring in 2000.
During the 1997 to 2001 period, El Niño and La Niña produced the sort of impact upon natural gas prices that one might logically expect:
Looking out over a longer period of time, however, the El Niño/La Niña cycle’s impact upon natural gas prices has been far from evident and often counterintuitive.
As such, to analyze the relationship between El Niño, La Niña and the evolution of natural gas front month prices, we constructed three time series of synthetic spot prices using 1st nearby futures prices:
The nearby future (the contract closest to expiry) is the contract most closely tied to the Henry Hub spot price. As such, using a time series of the nearby futures contracts without properly rolling them (reinvesting one contract into the next as it comes to expiry) can be a proxy for the evolution of the spot price. Moreover, stringing together the nearby contracts to create a synthetic spot price has the advantage of daily pricing. In actuality, spot price transactions don’t occur every day, leaving gaps in that time series --a problem that is easily avoided in the deeply liquid futures market.
Figure 4 shows that since the Henry Hub Natural Gas futures began trading in April 1990, the spot return of natural gas tended to be positive under El Niño and negative under La Niña with most of the difference coming after the year 2000. This result is counterintuitive given that El Niño typically produces warmer than normal temperatures in the Northern US, where wintertime demand for natural gas is the highest. During the 1990s, natural gas spot prices behaved in a fairly similar fashion overall under El Niño and La Niña –in spite of the aforementioned 1997-1998 El Niño and 1998-2001 La Niña. It wasn’t until after the year 2000 that the two time series began to diverge.
Much of the divergence appears to be coincidental. Natural gas prices went higher (+558% spot) during the mild El Niño that occurred between February 2002 and September 2005 for reasons that had little, if anything, to do with the weather. The February 2002 to September 2005 period witnessed an enormous run up in commodity prices in general (West Texas Intermediate crude oil + 228%, gold + 65%, high grade copper +149%). This phenomenon was driven in part by constrained supply growth in many commodities (including natural gas), a weak US Dollar, lower than normal US interest rates following the 2001 recession, a rebound in US economic activity beginning in 2003, and strong growth in emerging markets.
Hurricane Katrina, which struck in August 2005, at the tail end of this period of mild El Niño, also significantly boosted natural gas prices as Gulf of Mexico supplies were significantly disrupted. It should be noted that hurricane landfalls are statistically less likely under El Niño than they are La Niña (see NOAA’s study on the Effect of El Nino on U.S. Landfalling Hurricanes, Revisited (Bove, O’Brien, Elsner, Landsea and Nin: http://www.aoml.noaa.gov/hrd/Landsea/elnino/). So, here too, the Katrina-related rise in prices that occurred at the tail end of the 2002-2005 El Niño is probably coincidental.
Likewise the decline in spot prices that occurred under La Niña conditions in 2006 also appears to have little to do with the weather. A mild La Niña began in October 2005 which coincided with a return to normal in Gulf production and a decline in natural gas prices. This unwinding of long positions famously led to the collapse and liquidation of Amaranth Advisors, which held a large long position in natural gas, which was definitively liquidated in September 2006.
Finally, La Niña conditions prevailed during the period from March 2007 to April 2009, encompassing the acute phase of the financial crisis. While natural gas spot prices rose 58% during the period from March 2007 to early July 2008, they subsequently fell by 76% between early July 2008 and April 2009, mirroring the behavior of crude oil. Overall, they fell by 58% during the “financial crisis La Niña” for reasons that had far more to do with a recession-related softening of domestic demand than they did with changes in weather patterns.
As such, while it is interesting that natural gas spot prices have risen by a cumulative 659% under El Niño and fallen by a cumulative 75% under La Niña, we don’t put much stock in these numbers for the reasons outlined above.
The NOAA Index has risen to a level of +0.9°C above normal in May and probably rose further in June, indicating that we have begun an El Niño that could continue to intensify significantly into the fall and winter. While El Niño has been fairly reliable in the past at bringing cooler, wetter weather to the Southern United States and moving the storm track southward, it has produced less reliable impacts on fall and winter weather in the North. It is entirely possible that we could still see a cold snap in the fall that sends natural gas prices higher. Likewise, it is also possible that a warmer-than-normal winter in the Northern part of the country will lead to lower demand and prices for natural gas.
The data make clear that El Niño and La Niña are not the primary drivers of natural gas prices over long periods of time– except that powerful El Niños, like the one in 1997-1998, have the potential to disturb US weather patterns sufficiently enough to create strong trends in the natural gas markets. The same can be said of extended periods of La Niña like the one that followed the 1997-1998 El Niño and lasted for three years.
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 authors 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.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.
Adila Mchich is Director of Energy Resources & Product Development at CME Group.
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