The article below is an excerpt from our Q2 2023 commentary.
In our view, natural gas prices are reaching a turning point. Gas spiked to decade highs last spring following Russia’s invasion of Ukraine, only to fall back on milder-than-normal winter weather. Instead of running out of gas, traders worried about running out of storage as prices collapsed to near-all-time lows.
During market panic or euphoria, investors make the mistake of linearly extrapolating current trends. As a result, they fail to see the ground shifting underneath them and miss out on excellent opportunities. Natural gas represents a classic buying opportunity, and we believe investors are again focused on all the wrong issues.
Only several weeks ago, we heard many analysts openly question whether the US would run out of natural gas storage before the end of the injection season. Such an event would create the dreaded “gas on gas competition,” potentially driving prices to zero (or below). With the injection season half complete, these concerns were unfounded. Inventories started the year in line with seasonal averages. Extremely mild weather resulted in nearly 5% fewer heating degree days between January and April, significantly reducing heating demand. Inventories grew to 382 bcf above seasonal averages by April. Mild winter weather was followed by a mild start to summer. Cooling degree days in April, May, and June were nearly 30% below the five-year average, reducing air conditioning demand. Despite the milder than-normal start to summer, US inventories did not grow relative to seasonal averages. By mid-June, inventories remained 385 bcf above average. As the weather turned warmer in July, inventories have started to come down and currently stand at 320 bcf above average, the lowest level since February. Notably, July was 3% milder than average, suggesting the market would be in an even more significant deficit had temperatures been average. Liquefied Natural Gas (LNG) exports help explain why US inventories declined relative to seasonal averages despite mild weather. LNG demand reached a record of 12.5 bcf/d in May as Freeport returned online after a damaging fire left it inoperable for over a year. Based upon our analysis, the likelihood of full storage by the end of the injection season in the fall is very low; gas prices will likely rally from here.
Over the next two years, an additional six billion cubic feet of LNG exports will come online at Golden Pass, Plaquemines, and Corpus Christi. Another 1.6 bcf/d is due to come online at Port Arthur in 2027. Where will these facilities source their gas?
In our last letter, we explained how the same depletion issues plaguing the oil shales are also at work in the gas shales. The Marcellus represents 25% of all US dry gas supply and has not grown in nearly two years. Production peaked in late 2021 at 26.5 bcf/d – almost one bcf/d higher than current levels. The Permian produces natural gas alongside oil, but declining productivity across the basin suggests sustained growth will be difficult. The Haynesville surged to nearly eight bcf/d by 2011 before declining by half through 2017. Renewed interest led to a second period of growth, until by late 2022, production peaked at 14.3 bcf/d. Unfortunately, production has now been flat for eight months.
The Haynesville is deep and highly over pressured, resulting in elevated drilling and completion costs. Companies raced to lay down rigs as prices fell from $7.00 per mcf in December 2022 to $2.00 by February 2023. After peaking at seventy-two rigs in December, there are now only forty-four rigs operating in the play, with most of the decline occurring in June. Production often follows drilling with a several-month lag. If seventy-two rigs cannot produce much growth in the first few months of 2023, then production will likely fall from here. High prices would likely incentivize increased drilling in Haynesville, similar to what happened in 2017. However, the field had only produced 20% of its reserves back then compared with nearly 50% presently. It will likely be more challenging—if not impossible-- to boost production this time once basin-level declines take hold, considering it is a much more mature play.
Our models tell us we have overbuilt our LNG export capacity without adequately considering where the upstream feedstock will come from. US natural gas remains by far the cheapest unit of energy globally by as much as 75%. Once demand, driven by LNG expansion, exceeds domestic supply, our expectation is that this discount will evaporate, sending US gas prices up several-fold, as US prices converge with international prices.
Turning to Europe, hot summer weather was not enough to offset their record mild winter (air conditioning in Europe remains less prevalent than in North America). European gas storage is now 88% full compared with an average of 74% for this time of year – a surplus of 14 percentage points. While still high, this is much lower than the record set after the winter on March 26th when inventories reached 56% full, a 22% surplus compared with seasonal averages. In March, the German energy minister Klaus Mueller warned that Germany would run out of natural gas by January 2024 on colder than average weather. Considering inventories at the time were running further ahead of seasonal averages than they are today, we would expect his concerns have not lessened.
Both US and global natural gas markets rest on a knife’s edge. After last year’s incredibly mild winter, inventories are no longer at dangerously low levels. However, the longer-term supply and demand trends point to extreme tightening, particularly in the US. Investors are extrapolating current trends but missing the significant shifts taking place. They should take heed.
Intrigued? We invite you to download or revisit our entire Q2 2023 research letter, available below.
You may also listen to our roundtable discussion with Marko Papic, Parter & Chief Strategist of Clocktower Group (recorded in September 2023), "Russia's Role in Geopolitics: Navigating Natural Resource Investments in a Shifting Landscape."
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