Increased natural gas trading by primarily institutional investors and a rise in commodity prices globally — combined with modest tightening in gas supply-demand balance in the first half of 2008 — contributed to the sharp rise in both spot and futures gas prices last year, FERC said in its “State of the Markets Report” for 2008.

The Federal Energy Regulatory Commission’s Division of Energy Market Oversight (EMO), which prepared the report, believes that the financial fundamentals played more of a part in the gyrations in futures prices and the Henry Hub spot price in 2008, which rose to $13.32/Mcf last July and crashed at $5.71/Mcf by year-end. There was no “physical explanation” for spot prices to climb to the $13/Mcf range, according to the report, which was released Wednesday. FERC released a summary version last April (see Daily GPI, April 17).

“While physical market fundamentals, particularly relatively low gas in storage, explain part of the rise for both futures and spot gas prices, there’s no physical explanation for prices in the $13 range,” the report said.

“However, the rise in gas prices did coincide with a global increase in many commodity prices, which occurred as large pools of capital flowed into various financial instruments, turning commodities such as natural gas into investment vehicles. [The EMO] staff believes that it was the upward pressure of financial fundamentals on top of a modest tightening of the supply-and-demand balance for gas in the first half [of] 2008 that explains the path of natural gas prices during the year,” the report said.

“The past few years have seen a large influx of passive investments, primarily from institutional investors, into commodities in general and natural gas in particular through vehicles such as exchange traded funds,” it noted. In May 2008 Michael Masters, portfolio manager for Masters Capital Management LLC, told Congress that assets allocated to commodity index trading strategies rose to $260 billion by March 2008 from $13 billion at the end of 2003.

He also reported that natural gas purchases by passive investors in commodity index funds increased to more than 2,263 Bcf by the first quarter of 2008 from 331 Bcf at the start of 2003.

“Passive investment in commodities is not manipulation, nor is it necessarily bad for market outcomes. Passive investors and active speculators can enhance price signals to producers and consumers that energy markets are tight by bidding up prices, in effect magnifying the impact on prices of underlying fundamentals. Such a phenomenon likely contributed to the rapid rise in gas prices and other commodities during the first half of 2008 and the subsequent collapse of commodity prices during the second half of the year,” the FERC report said.

In addition, “we believe that some of the increase in prices was the result of market perceptions and technical trading strategies. These technical trading strategies include the tendency of commodity traders to trade in a manner that is consistent with the prevailing price movement. Thus, some technical traders buy as the price is moving up and sell as the price is moving down,” it noted.

The strategies result in the accumulation of long positions as prices increase and the accumulation of short positions when prices fall. The report said the average monthly open interest in the natural gas prompt month climbed 109% to 106,000 contracts in the summer of 2008 from 50,759 contracts in 2006, as average monthly gas prompt prices climbed 38% to $12.78/Mcf in June 2008 from $9.23/Mcf in 2006. And as prompt month gas prices fell to $5.74/Mcf at the end of 2008, interest fell 25%, according to FERC.

The markets report said there were no major disruptions to cumulative supply during the first half of 2008 that would explain the increase in prices. It estimated that total gas supply, including pipeline imports from Canada and liquefied natural gas, increased between 1.3% and 3% during the first half of the year. At the same time cumulative gas demand through June 2008 rose between 2% and 3.6% relative to 2007, it said.

“While the growth in consumption during the first half of 2008 could have contributed to upward pressure on natural gas prices, demand alone does not seem to explain the overall level of natural gas prices. This is especially true because the growth in demand was concentrated in two months (January and March), while spot prices continued to rise in April and May,” the report said.

“Importantly, there was not an exceptional surplus of gas supply in July 2008 when prices started to plunge. August does not show a significant supply surplus due to the low summer demand from power generators; however, the market balance was only mildly different from the five-year average and previous two years,” according to FERC.

On the storage front, inventories “remained at the five-year average through the end of May and then dropped to levels in early July that the market had not experienced since 2004. Because the relatively low storage levels during the price run-up occurred in the spring and early summer, when those injecting gas have the maximum flexibility in their storage choices, the steep price increase likely caused the low inventories,” not the other way around, the report said.

“While 2008 storage was at or above the five-year average most of the year, 2008 prices were far above other periods of similarly moderate storage levels. Specifically higher summer storage deficits occurred in the summers of 2000 and 2003, without a similar impact on summer prices,” FERC noted.

The report further said the natural gas pipeline infrastructure burgeoned in 2008. The Energy Information Administration estimated that new interstate and intrastate pipeline projects added an unprecedented 43.9 Bcf/d of capacity last year, almost three times the capacity additions from previous years.

“Some of the most significant pipeline capacity additions altered traditional flow patterns and transformed physical transportation price relationships…Increased gas flows from the Rockies Express Pipeline (REX) and new shale supplies put downward pressure on Midcontinent prices, which were, at times, the lowest cost markets in the United States in 2008. The separation of prices in northern and southern California grew by 30 cents, a 64% increase from 2007, as Permian gas displaced by REX depressed southern California prices,” the report said.

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