Should You Trust Weather Predictions From the Government?

Demand for natural gas has reached record highs at different times throughout this season, and investors should have taken notice. This increased demand is almost entirely accounted for by the colder weather combined with the growing use of natural gas as a heating fuel. As temperatures and stock prices continue to drop, adding utility companies and natural gas producers to your portfolio may seem like a logical way to provide stability during an otherwise volatile season.

However, potential buyers using the cold weather as a reason to enter the natural gas industry should be aware that the U.S. Energy Information Administration (EIA) is projecting warmer weather in 2014. Do you trust the EIA to predict the weather, or are you better off making your own predictions?

Weather versus value in natural gas
Before looking too deeply into weather forecasting, lets first evaluate the premise that cold weather and increased natural gas demand equate to favorable investing returns from utility companies and natural gas producers.

Like all commodities, the supply and demand of natural gas directly affect its price. The futures market slightly complicates the natural gas commodity market that would otherwise obey the basic demand-based pricing rules of macroeconomics by adding in the components of expected supply and expected demand. Though an increase in demand and a decrease in supply would, under less convoluted circumstances, lead to an increase in the price of natural gas, if the magnitude of the increases or decreases does not match expected values then the price increase may not be realized.

This is where making short-term investments in major natural gas producers like Chesapeake Energy (NYSE: CHK  ) , Anadarko Petroleum (NYSE: APC  ) , and Southwestern Energy (NYSE: SWN  ) makes for volatile and unpredictable returns. Weather fluctuations and cold spells equate to higher demand for natural gas, but the demand is often short-lived and built into the futures prices of the fuel. Over the long haul, increased demand will cause price increases, but only if the demand is sustained throughout the season.

Difference between weather and climate
Sadly, being able to predict the weather is not a skill that can be applied to make millions off of natural gas investments. Predicting the climate, on the other hand, may be slightly more helpful.

Weather pertains to atmospheric conditions over a short period of time, whereas climate refers to atmospheric conditions over long periods of time. Models for predicting climate change are entirely different than those for predicting the weather. When the EIA predicted a 2.2% drop in natural gas consumption in 2014 based primarily on expectations for a decline in heating-degree days (HDDs), they were essentially predicting atmospheric conditions over a period that does not fit clearly into either the weather or the climate category.

Heating degree days are based on outside air temperatures that provide a measure for how often a given location would need to run the heat and in turn consume heating fuel. Over the course of the next 30 years as has been done over the past 30 years, one could model a likely decrease in HDDs due in part to climate change, but accurately predicting yearly fluctuations is a process that goes beyond the capabilities of NASA and the nation's best University researchers, much less the EIA. Basing an investment thesis on the EIA's forecast of how warm 2014 or 2015 will be is akin to basing investment moves on Punxsutawney Phil's predictions. If the start of 2014 is any indication, the groundhog may actually give you better insight.

The takeaway
Natural gas consumption will not significantly drop off regardless of yearly weather fluctuations or the EIA's ability to accurately predict the number of yearly heating days across the country. What the EIA can better project is the portion of Americans that will utilize natural gas to heat their homes and the portion of natural gas that will be used for electricity generation, both of which are expected to slightly decline over the near future.

Looking at the big picture, ExxonMobil (NYSE: XOM  ) anticipates that natural gas will pass coal as the second most-used fuel worldwide in just over a decade. As an investor your decision on natural gas may come down to who you believe can better predict the future of energy use, Big Government or Big Oil. Who do you believe?

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