John Kemp, Reuters

U.S. natural gas prices plunged on Jan. 3 amid forecasts that temperatures will be average or higher across most population centers by the middle of January.

Earlier forecasts had predicted colder temperatures would persist through most of January, boosting heating demand.

But the correction in gas prices comes after hedge funds had amassed unusually large bullish bets, helping drive prices up by more than 40% in the last two months.

Once some of the frothiness caused by the big buildup of hedge fund positions has been blown off, prices are likely to continue trending upwards in 2017.

Polar Vortex

Futures prices for gas delivered to Henry Hub in February fell on Jan. 3 by almost 40 cents per million British thermal units, or nearly 11%.

Prices for gas delivered in July were down more than 25 cents, or around 7%, compared with the previous close.

The trigger for the sell-off seems to have been revised weather forecasts showing temperatures across most of the U.S. would be higher by mid-January.

The projected weakening of the circumpolar vortex had been expected to allow masses of much colder air to wander south over the U.S.

It now appears likely that the worst of the cold will occur over the Eurasian landmass, while temperatures will be normal or above normal over most of North America.

Hedge Funds

The plunge in front-month prices was the largest for almost three years, but came after they had risen 42% since early November.

By the end of 2016, hedge funds had amassed the largest net long position in natural gas futures and options for more than two years.

Hedge funds held a net long position equivalent to 2,927 billion cubic feet (Bcf) of gas on Dec. 27, according to an analysis of data published by the U.S. Commodity Futures Trading Commission.

Fund managers’ net position had increased by the equivalent of 1,641 Bcf or 128% in just six weeks.

The concentration of positions left the market vulnerable to a correction once prices stopped rising and funds attempted to take some of their profits.

Tight Market

Despite the sell-off, the underlying state of the gas market appears tight, which is a big turn round from first-quarter 2016.

U.S. working gas stocks in underground storage declined by 687 Bcf during the final six weeks of 2016, the largest seasonal decline since 2013.

By Dec. 23, stocks were 413 Bcf, or 11%, below the level at the same point in 2015, according to the U.S. Energy Information Administration.

Stocks were also 79 Bcf, or 2%, below the 2011-2015 average, the first time in 2016 stocks had fallen below the five-year average.

The enormous glut of gas left at the end of the winter of 2015-2016 has been erased by the very low prices which prevailed through most of 2016.

The number of rigs drilling for gas in the U.S. fell to its lowest level for more than a quarter of a century in August 2016 as producers scaled back work on new wells.

Meanwhile, the combination of above average temperatures from the end of May through September and low gas prices encouraged record gas combustion by electricity producers.

Warm Autumn

The U.S. gas market has been tightening consistently since April as production has fallen and consumption has soared.

The full extent of the tightening has been masked until recently by the unusually mild start to the 2016/17 heating season.

Unusually warm weather last summer, which caused gas stocks to rise much more slowly during the injection season, lingered into autumn, causing stocks to start drawing down later than normal.

Concerns about storage space running out resulted in a sharp drop in prices during the second half of October and the first half of November.

But the arrival of the first blast of much colder than normal weather in December and a second cold spell forecast in early January has shifted attention back to the underlying market tightness.

Enormous draw downs in gas stocks in the first three weeks of December have underscored just how much tighter the market has become.

Gas stocks fell in December much faster compared with 2015 than can be accounted for by the cold weather alone. Stocks fell by an extra 144 Bcf in the first three weeks of December after adjusting for temperatures.

Stocks have now fallen below the five-year average even though heating demand so far this season has been 18 percent below the long-term average.

2017 Outlook

Gas drilling has picked up in response to rising prices, with the number of rigs up from a low of 81 in August to 132 at the end of the year, according to oilfield services company Baker Hughes Inc.

The much larger increase in oil-well drilling since May will also increase gas supplies through the production of more associated or casinghead gas.

But gas consumption is also set to rise this year as another 11.5 gigawatts of gas-fired power generating capacity is installed by the end of 2017.

Super-efficient combined-cycle gas turbines (CCGTs) are displacing smaller, older, less-efficient and less-flexible coal-fired power plants.

So gas prices will need to be higher on average during 2017 to sustain increased drilling and curb gas consumption by reducing the number of hours run by CCGTs.

Once some of the speculative froth has blown off the gas market, prices are likely to resume rising.