Why energy traders need accurate weather forecasts

Businesses – large and small – are impacted by weather. For example, offshore oil and gas companies need to have access to specific weather information to help them make important decisions about protecting billion dollar assets. And, another business sector that’s heavily impacted by weather—and weather forecasts—is energy trading.

There is an active market for natural gas purchases and sales. This consists of futures contracts that define at what date and for what price a party must buy or sell natural gas from or to the other party.

Many factors affect the supply and demand for natural gas, which moves the price of these contracts. However, the most significant driver for supply changes—at least in the short term—is the weather, with the temperature being the primary factor. For example, if a cold blast is forecast in the winter, natural gas prices will generally go up because furnaces are cranked to keep buildings warm. Similarly, when a heat wave is forecast in the summer, natural gas prices may go up because more electricity is required to handle the high air conditioning load, with a large portion of that electricity generated in natural gas power plants.

Natural gas traders and hedgers can be grouped into three types:

Producers of natural gas who sell their production and want to secure commitments in advance to lock in prices or guarantee sales
Buyers of natural gas, including those in the industry who generate electricity, as well as commercial and residential users (see pie chart below)
Speculators, those who seek to generate profits by buying and selling futures contracts without ever producing or purchasing natural gas

The impact of demand on energy prices also depends on where weather changes are taking place. For example, extreme heat or cold in the northeast has a bigger effect than if substantial temperature anomalies take place in less populated parts of the country.

For these reasons, natural gas and energy traders demand forecast information that details both when and where major weather changes are expected to occur. Both short- and long-range forecasts are essential as they require information about what is expected to take place over the coming days, weeks and months.

Energy markets are affected by the slightest changes. Even a minor overnight change in a weather model or forecast can impact prices. In the winter, it’s not uncommon for a new, colder forecast to drive up energy prices by 5 percent, particularly if supply is already low. Therefore, if a natural gas or energy trader can get a better forecast or faster forecast of a coming change than other traders, they can get an advantage in the marketplace.

To meet this need, DTN prepares a suite of forecasts, ranging from real-time updates every hour to seasonal updates provided every two weeks. These forecasts detail expected temperatures compared to normal for several time periods: 1 to 15 days, 16 to 30 days and one year out. Most often, these forecasts are provided in “population-weighted heating or cooling degree days.” This means that forecasts of temperature are converted into parameters that closely estimate heating or cooling demand (how much the temperature is above or below 65 degrees), weighted for areas that have higher population because that is what drives domestic demand.

In addition to helping energy traders anticipate likely changes in the demand for electricity based on the weather, forecasts also play a role in determining the supply of electricity—and the resulting demand for natural gas. In the last five years, wind power has grown significantly, affecting the amount of natural gas that’s needed to produce targeted levels of electricity. Wind energy can comprise as much as 30 percent of the electricity that’s created in the U.S. on a given day.

Given the increasing importance of wind in the creation of electricity as well as the significant reduction of demand for natural gas, DTN launched a wind power forecast that details expected output (in megawatts) for individual wind farms and regions. These forecasts are made for nearly every wind farm in the U.S. and Canada and are aggregated together to give natural gas traders another tool in their arsenal to estimate future demand for natural gas.

The way that natural gas prices change over time is a complex process that takes into consideration a variety of factors. Weather, however, is perhaps the most important. Energy traders that are armed with the best, fastest and most detailed forecasts are in the best position to be successful and profitable in a market where millions of dollars can be won or lost in a brief time.