Energy commodities such as natural gas and oil are among the most volatile instruments in the financial markets. Trading them can be very lucrative, but without proper analysis and money management, traders can fall victim to big moves either way. In today's article, however, we'll take a look at a trick that has been in the arsenal of professional energy traders for decades. It involves analyzing the weather in major producing areas.

After all, weather plays a key role in influencing supply and demand. Weather conditions directly affect energy consumption and production, so weather forecasting is a very valuable tool for traders. Don't worry, you won't have to become a weatherman or weatherwoman, but in today's article, we'll show you some basic tips on how to work with weather when trading energy commodities.

The impact of weather on commodity markets

The weather affects our daily lives, but for most of us, the weather is just a matter of a nice or bad work commute or a ruined day on the beach during vacation. But not for traders who can use weather analysis to improve their results significantly. That’s because weather has a significant impact on the markets. It is clear to everyone that a major storm can cause damage to fields and therefore threaten the production of many agricultural commodities

Did you know that: according to Germanwatch estimates, between 1997 and 2016, US GDP grew 0.255% slower each year than under optimal weather conditions?

The impact of extreme weather events on markets and the economy as a whole can be enormous.

It is not so surprising that something like trading of weather futures contracts has emerged in the market. This relatively new but rapidly growing market allows companies and investors to hedge the risk associated with unpredictable weather changes. Weather futures emerged in 1997 and have since become an important risk management tool in various industries such as energy, agriculture, and tourism.

For the purposes of today's article, however, we will make do with weather and its effects on the oil and natural gas market.

The impact of weather on natural gas prices

Natural gas is the primary source of heating. During cold winters, especially in the Northern Hemisphere, demand for natural gas rises sharply as households and businesses increase their heat consumption. A colder-than-expected winter can lead to sharp price increases. In contrast, natural gas is used in summer to generate electricity to power air conditioners. Hot summers can lead to increased demand for natural gas, which leads to higher prices. However, natural gas is not only sensitive to temperature fluctuations, its production can also be significantly affected by hurricane season. Hurricanes can disrupt natural gas production by damaging infrastructure and temporarily halting production.

The chart below shows the recent evolution of the US natural gas price. Two distinct trends are evident. The first trend is downward from the beginning of the year to mid-February. During that period, a trader would logically expect the price of natural gas to rise, as this is the peak of the winter and heating season. However, this winter has been one of the mildest in U.S. history, so demand for natural gas has been falling significantly while inventories have been rising. As a result, prices have fallen by around 50%.

The second trend is upwards, with the weather again playing a role in the price of natural gas towards summer - this time with very high temperatures across the US. Thus, the demand for natural gas for air conditioners increased significantly, and, in addition, producers started to reduce production in the spring, as it was not worthwhile to do so with such low natural gas prices. However, at the beginning of the summer, we are again seeing a price correction, again caused by the weather - this time temperatures in the US are lower than expected.

In the natural gas market, the well-known trader's adage - "buy the rumor, sell the news" - often applies. This can mean potentially buying natural gas if the prospect of high summer temperatures within a few weeks is announced. However, by the time those temperatures occur, the market is already interested in the outlook for the next few weeks.
 

_{Natural gas development from the beginning of 2024. Source: MT4}

The impact of weather on oil prices

Oil is not too fond of big temperature swings either. Extraction equipment is very sensitive to extreme temperatures and, in particular, severe frosts can significantly reduce production and shut down wells for several weeks. Much has also been written about the effects of hurricanes on the oil market - refineries and oil wells are very vulnerable to extreme weather events. Hurricanes can halt their operations, reduce supplies and increase oil prices.

In addition, a significant part of US oil production is concentrated in the area around the Gulf of Mexico (see figure below). The latter is regularly battered by hurricanes from June to November. Weather can also affect the transport of oil - for example, ice can make shipping routes difficult and hurricanes can disrupt pipeline operations. Adverse weather can affect the entire supply chain from production to delivery, which in turn affects oil prices.
 

_{Oil production in each US state (thousands of barrels per day, 2020). Source: Wikipedia}

Historical examples of the impact of weather on oil and gas prices

Hurricane Katrina (2005)

Hurricane Katrina, one of the most devastating hurricanes in US history, significantly affected oil prices. It caused widespread damage to oil platforms, refineries and pipelines in the Gulf of Mexico, which is crucial to US oil production. As a result, oil prices have risen from around USD 65 per barrel to more than USD 70 per barrel in a very short period of time.
 

Hurricane Harvey (2017)

Hurricane Harvey caused widespread flooding and damage in Texas, where many refineries and petrochemical plants are located. The hurricane led to a temporary reduction in crude oil production and refinery capacity, causing gasoline prices to spike. Oil prices also experienced volatility, although the global oil surplus at the time mitigated the sharp increase in prices.
 

Polar Vortex (2014)

The polar vortex in early 2014 brought extremely cold temperatures to the US, leading to record high natural gas consumption for heating. This surge in demand caused natural gas prices to jump from approximately $4 per million British thermal units (MMBtu) to over $6 per MMBtu in one month.
 

_{Natural gas price increase at the beginning of 2014. Source: Finviz}

Is 2024 the year of opportunities?

A tropical storm called Beryl is currently battering Texas, USA. There has been great concern in the US about the damage caused and also the impact of this storm on oil production and oil infrastructure. Texas is an absolutely key state for oil production - over 40% of US oil comes from this state. As a result, the price of WTI crude oil reached USD 85 per barrel, the highest level since the end of April.

Fears about storm Beryl have not yet been confirmed, as it was originally a hurricane, but its intensity has weakened as it entered US territory. Even so, the Shell oil company, for example, was forced to suspend the operation of one of its oil platforms, which produces around 100 000 barrels of oil a day.

However, the effects on the fuel market should be minimal, which is very good news given the start of the main motoring season. The market feared even more disruptions to oil infrastructure, and the expiration of the risk premium has resulted in a barrel of WTI oil falling below $82.
 

However, according to an analysis by the University of Colorado, the US is facing an abnormally active hurricane season this year. Between 1991 and 2020, there was an average of 7 hurricanes in the US each year, but 11 are already expected this year - 5 of which are expected to be very severe.

The number of days the US will face hurricanes should also be significantly above average. The long-term annual average is 27, with 45 days expected this year. A total of 13 of those days should then fall on very severe hurricanes, almost double the long-term average.

This means that major disruptions in US oil production are likely to occur during the summer, which could be felt around the world - the US is the world's largest oil producer. Texas is also a key state for natural gas production - around a quarter of US gas is produced here. Hurricanes can also significantly affect natural gas production. So 2024 could be a year full of opportunities for oil and gas traders.

How to incorporate weather analysis into your strategy?

Energy markets are influenced by many factors at once, so it is not for nothing that they are some of the most volatile instruments on the market
 

Traders must watch:

• the geopolitical situation,

• the OPEC cartel's production trends in oil,

• stocks, production and consumption.

Furthermore, macroeconomic indicators such as:

• interest rates,

• inflation,

• labour market, etc.

This knowledge is then supplemented by technical analysis and a consistent money management. Thus, trading energy commodities is definitely not easy. If you have the aforementioned indicators in the palm of your hand, tracking the weather can give you an added advantage.

More tips on how to incorporate weather analysis into your trading strategy:

1. Follow the weather forecasts
   Focus on short-term weather forecasts (1-14 days) to predict immediate changes in heating or cooling demand. Shorter forecasts are then suitable for traders on a shorter timeframe. Seasonal forecasts (1-3 months) then help predict long-term weather fluctuations that could affect energy consumption. Longer-term forecasts are thus suitable for swing traders. For weather tracking, we recommend the NOAA, AccuWeather or Windy sites.
    

2. Supply and demand analysis
   Use weather data to estimate changes in heating or cooling demand. Cooler winters and warmer summers typically increase demand for natural gas. Find out what the demand is for electricity and gas. Also evaluate how weather events can disrupt production. Hurricanes and extreme cold can hinder the production and transportation of oil and natural gas. A key resource here is the U.S. Energy Information Administration, or EIA. Another important indicator is the number of active oil wells, which is tracked by Baker Hughes.
    

3. Analysis of historical data
   Backtesting is crucial for any strategy. The same is true when using weather for trading. So examine how past weather events have affected commodity prices to identify patterns and make informed predictions. Again, historical data on production, stocks and demand can be found at EIA.
    

4. Use technical analysis
   However, weather analysis alone is not enough to enter a trade. So combine weather data with technical analysis to identify entry and exit points. Look for trends and price movement patterns influenced by weather conditions. Always use stop-loss orders and position sizing to manage risk, as weather forecasts are not always accurate.

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