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Is the US Natural Gas Market heading for a winter of discontent?
US natural gas prices have surged in recent months, up 139% in October compared to a year ago, as concerns over adequate winter supply emerged. The combination of stagnant production, strong demand fueled by surging liquefied natural gas (LNG) exports, and diminished demand elasticity from the electric power sector have all played a role.
A collapse in oil and gas prices in early 2020 led oil and gas companies to significantly pull back activity to hold capital spending in line with deteriorating cash flows, and as a result production fell sharply during 2020. Production recovered modestly heading into 2021 as shut-in production was brought back online and companies completed some DUCs. However, continued capital discipline in 2021, despite strengthening oil and gas prices, has held natural gas production flat throughout the year.
We do expect drilling activity to increase in 2022 in response to stronger oil and gas prices; however, the time lag between when wells are drilled and then begin production should keep the market tight and Henry Hub prices elevated through next spring.
Global LNG trade for the first ten months of 2021 were up 6%, driven by economic recovery in Asia and low hydroelectric power generation in Latin America. Supply outages of LNG export capacity in the Atlantic Basin contributed to a tighter market. This has supported US LNG exports, with feed gas demand up 60% through the first ten months of the year.
Commercial operations are expected to begin at Sabine Pass LNG Train 6 and Calcasieu Pass LNG this winter, providing further upside for LNG feed gas demand. Henry Hub natural prices would need to increase to unheard-of levels to incentivize voluntary US LNG curtailments. Demand for US LNG will be very robust. Henry Hub gas prices would need to rise to international price levels of well over $20/MMBtu even to consider possible curtailment of US facilities which is highly implausible.
A delicate balancing act between natural gas and coal power
Over the past decade the US natural gas market has largely balanced through switching between gas and coal in the power sector. Gas prices rising during winter 2020/21 led utilities to increase coal utilization significantly, drawing down coal stockpiles, leading to a constrained coal market at the end of the summer 2021. Labor shortages, among other factors, have thwarted coal producers' ability to increase production even as coal prices increased. Moreover, significant retirements of coal-fired power plants this past decade have eliminated 32% of the coal fleet.
Without the benefit of excess coal stockpiles or a significant uptick in production the thermal coal market is forced to operate in a more constrained and balanced manner. Further natural gas price increases are unlikely to yield significant additional increases in coal generation at the expense of gas generation providing the demand elasticity the natural gas market had grown accustomed to this past decade.
This change in the historical pattern of gas-to-coal switching is adding new demand strength for gas-fired power generation at a time when demand from other sectors is also rising. The economic recovery from the global COVID-19 pandemic has spurred industrial demand. Taken together, they have added to the stout demand for feed-gas at US liquefaction facilities.
Such tight market conditions have the potential to translate into volatile winter Henry Hub gas prices. The market is under pressure this winter because two of three sources of short-term flexibility are insufficient—ramp up on the supply-side and switching from gas to coal on the demand-side. Nevertheless, the third source of flexibility, storage, should allow the market to make it through winter unscathed unless winter weather is very severe.
Strong demand to spur strong growth in natural gas production beyond the winter
We expect production to increase this winter, rising by 3 Bcf/d winter-over-winter, as strong demand and strengthening natural gas prices spur robust growth from the Haynesville play.
Along with growth in Haynesville production this winter, we also expect natural gas inventories to hover near the five-year-average in our base case which assumes average winter weather, and this has the potential to put downward pressure on prices and lower than where NYMEX has been trading.
Still, prices will likely remain elevated through winter overall as market participants conserve storage inventories until there is a line of sight to getting through winter. Winter storm Uri in February 2021 has not been forgotten when a polar vortex reached deep into Texas curtailing natural gas supply and causing major disruptions to the electric power grid.
In our winter base case, we expect Henry Hub natural gas prices to average about $5MMBtu. A milder winter would send prices back toward $4/MMBtu rather quickly. However, should the winter bring forth early or prolonged cold, the natural gas market is liable to be reactive and create additional pricing volatility. In such a case, a cold winter could see Henry Hub gas prices averaging between $10-20/MMBtu in some months. In this scenario we would likely see some industrials curtailing gas use. In our cold winter case Henry Hub natural gas prices average about $10/MMBtu.
Beyond winter we expect the natural gas market to begin to rebalance as more production works its way into the system. Despite the lackluster growth in production in 2021, higher prices are expected to spur a recovery in drilling activity given the undersupplied nature of the current natural gas market. We expect strong growth from the Haynesville in 2022 followed by a return to an associated gas-driven supply market heading into 2023 and 2024.
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