Why Backwardation Represents a Real Opportunity

May 30, 2017

For the past several months, the electricity prices for longer term contracts (36, 48, 60 months) have been lower than short term contracts (12-24 months) in many deregulated states. This is because the natural gas market, which tends to drive electricity prices, is in “backwardation”, defined as a market condition where the price of a future contract trades lower than its expected spot price. Currently gas contracts in 2019 are priced below contracts in 2018. Last month, we saw 2019 natural gas strips 11.3% lower than current strips and 4.4% lower than those for 2018.

Prices for 2018-2023 futures are comparatively low because the market anticipates gas supply will be more than sufficient to meet demand based on strong production growth in the years to come. For most of 2016, natural gas reserves maintained a huge inventory surplus. This excess supply produced historically low gas prices and subsequently historically low electricity prices through most of last year.

 table comparing electric price benchmarks at different term lengths in deregulated states

However, in early December of 2016 and continuing into January 2017, gas stock reserves fell back in line with—and eventually below—their year-over-year and five-year averages. This realignment of gas supply with demand levels moved gas prices dramatically upward from their record lows. Henry Hub natural gas prices rose from an average of $2.00/MMBtu in the first quarter of 2016 to a third-quarter average of $2.88/MMBtu and finally to an average price of $3.59/MMBtu in December. Natural gas prices rose 80% in the last three quarters of 2016.

The consumption of the huge surplus that drove prices so low in early 2016 was primarily due to declining production, rather than heightened demand. The decline in U.S. natural gas production is attributable to two major influences: negative basis pricing around the Marcellus and Utica shales, and the lack of pipeline infrastructure connecting these shale regions to higher-priced markets in the Midwest, New England, and Canada. When regional prices trade below Henry Hub and companies are physically unable to reach higher-priced markets, energy companies lack the incentive to increase natural gas production. As new pipeline capacity is built in and around the Marcellus and Utica shales, we should see increased production toward the end of 2017. The Trump administration seems poised to accelerate pipeline construction by removing regulatory hurdles. It is the anticipated development of new pipeline capacity in the New England, Mid-Atlantic, and the Midwest regions that is damping pricing for 2018 and 2019 futures, producing backwardation.

While FERC and the Trump administration are expected to dispose of regulations stalling Northeast pipeline projects, most of the projects are not expected to begin coming online until early 2018. Gas prices will likely climb throughout the remainder of 2017 as international exports increase and the economy grows, but expectations of additional pipeline capacity toward the end of 2017 will likely preserve the comparably low 2018-2023 futures pricing that currently make longer term electricity contracts so attractive.