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Evolving Energy Markets, Incorrect Forecasts Dominate 2006

The energy markets experienced a roller-coaster ride in 2006 as hurricane and weather forecasts ultimately ended up missing their marks, while electronic energy trading competition increased and the banks in the energy merchant sector continued to evolve from peripheral participants to core market players.

The energy merchant sector in 2006 was still in flux but competition was much stronger. "Banks are playing a much more important role in liquidity," said UBS Commodities Canada Ltd.'s Garth Doll, executive director. Doll spent eight years working for Morgan Stanley's energy trading arm and began working in UBS's Calgary office on Jan. 2. Going forward, he said, traders "will have to take the time to define what their strengths are" to clients.

What Doll expects to see more of this year is a continuing move by investment firms to make deals with energy companies that allow them to trade around physical gas and power assets.

"The appetite is to not just trade it, but to trade around the assets as well," he said. Doll noted the recent agreement between Highbridge Capital Management, a hedge fund majority owned by JP Morgan Chase & Co., and Louis Dreyfus Energy Group's merchant energy arm to form a new trading partnership (see Daily GPI, Jan. 9). "Banks are not shying away from putting capital behind their projects," he said. "It's been an interesting shift in the last three to four years. And I expect we'll see more of that in the future. The banks bring the liquidity, and liquidity is just what this market needs."

Suzanne Calcagno, who directs regulatory compliance for UBS Energy and UBS Commodities Canada, said that as the "price indices settled down, the idea that anybody could have an impact on the market has gone away. There is a lot less concern about the presence in the market of noncore marketers." The competition between the electronic exchanges "has made data more available. This is only a good thing. It helps with compliance, and the market is going to be less speculative about what's going on behind the scenes."

With the New York Mercantile Exchange (Nymex) joining IntercontinentalExchange (ICE) in round-the-clock electronic trading in June, the battle for energy trading market-share reached a boiling point in 2006. Nymex also joined ICE in becoming a publicly traded company following a successful initial public offering in November (see Daily GPI, Nov. 20, 2006).

With traders embracing ICE's electronic platform, Nymex responded by entering a technology services agreement with the Chicago Mercantile Exchange (CME) in April, under which CME's Globex electronic trading platform became the exclusive electronic trading services provider for Nymex's energy futures and options contracts (see Daily GPI, April 7, 2006; June 12, 2006). Energy volumes traded on Globex even outpaced Nymex's open-outcry pit trading on some days (see Daily GPI, Nov. 1, 2006). Both Nymex and ICE deemed 2006 successful, posting numerous full-year trading activity records (see Daily GPI, Jan. 4; Jan. 10).

The battle for market supremacy is expected to continue into 2007 on an even wider scale as traders and analysts monitor every move. In response to ICE expanding into agricultural trading such as sugar, coffee, cocoa and cotton through its recent merger with the 100-year-old New York Board of Trade, Nymex announced in December that it also would begin electronic trading of many of the same goods by the end of January (see Daily GPI, Dec. 22, 2006; Jan. 16).

What Hurricane Season?

After the hurricane-induced peak of $15.780 in December 2005, the futures market took a long slide to a low of $4.070 on Sept. 27, 2006 and finished the year at $6.299. Forecasts for a highly active and damaging 2006 Atlantic hurricane season failed to materialize. Hurricane forecasters such as the National Oceanic and Atmospheric Administration and AccuWeather said the seasonal activity was lower than everyone expected due to the rapid development of El Nino -- a periodic warming of the ocean waters in the central and eastern equatorial Pacific, which influences pressure and wind patterns across the tropical Atlantic (see Daily GPI, Sept. 20, 2006; Dec. 1, 2006). The big question entering 2007 is whether El Nino will help wipe out the entire winter for the eastern half of the nation.

"We started [2006] with natural gas firmly in the double digits -- historically pie-in-the-sky-high -- with many envisioning $20.07 riding on the heels of Hurricanes Katrina and Rita," noted Jay Levine, a broker with enerjay LLC. "Now we're ending the year firmly back in single digits...with many envisioning (taking artistic liberties here) $2.007. Following some early widespread cold temperatures, which were mainly a tease, the winter of 2006-2007 is thus far and mostly...a bust. And with it, [so are] prices."

Commercial Brokerage Corp.'s Tom Saal said he believes that 2006's quiet hurricane season in the Gulf of Mexico and mild winter weather were "anomalies" rather than trends. "The distinguishing factors of 2006 in the natural gas futures market was the hurricane season that never showed up and the winter that wasn't. It was basically the opposite of 2005," he said. "However, we did get enough air conditioning demand last summer to create some withdrawals from storage. Those were the three surprising events that happened last year."

Entering 2007, Saal noted that there is a significant amount of gas in storage, which is allowing the futures market to start out a lot lower than it started 2006. "Our high on the first day of trading in 2006 was $11, which is well above the $6.290 high on the first day of 2007," he said. "We opened the new year at a $4.710 discount to 2006, which I would say is pretty significant. The market has already factored in a lot of gas in the ground." Storage finished 2006 at 3,074 Bcf, while 2005 closed out at 2,641 Bcf.

Looking at the road ahead, Saal warned that 2007 might not get as many "free passes" as 2006 received. "I think we will see some winter over the next couple of months, and I think it would be safe to expect some hurricanes getting into the Gulf of Mexico as well this summer," he said. "All it will take is a couple of storms threatening or impacting the Gulf to produce stronger prices. As for the summer withdrawals, I think those might stick around. Air conditioning load continues to increase and the U.S. economy remains strong, which could team to increase summer gas demand once again."

A repeat of the quiet 2006 Atlantic hurricane season seems unlikely. Just last month, a respected London-based forecaster issued a much stormier outlook for 2007, predicting that 16 tropical storms are likely to occur in the Atlantic basin next season, including nine hurricanes and four so-called "intense," or Category 3-5 storms. Of the total number of storms forecast for the Atlantic basin, five likely will strike land in the United States, according to the Tropical Storm Risk (TSR). The TSR is compiled by Benfield University College London's Hazard Research Centre (see Daily GPI, Dec. 8, 2006).

Saal warned that despite the current weak market outlook double-digit natural gas prices could be seen again next winter if an active hurricane season teams up with another hot summer this year.

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