Natural gas prices in the U.S. for August delivery climbed to $2.90 per million Btu (MMBtu) on the last day of June, capping a 30 percent rally in just one month. Today’s prices are also the highest in nearly a year, ending an extraordinary run in which spot prices stayed below $2/MMBtu for much of that time.
Rock bottom natural gas prices occurred because of a confluence of events, a perfect storm that pushed prices down to unsustainable levels. Now, although the U.S. natural gas market is still oversupplied, there are reasons to believe that sub-$2/MMBtu could be over.
Historically low prices
In early March, natural gas prices dropped below $1.60/MMBtu, a level not seen since the end of the 20th century. This extraordinary decline in prices occurred for several reasons. First, natural gas production surged over the past decade. The shale gas “revolution” is not news, but production continued to climb unremittingly even though prices dropped and rig counts plunged to new lows. In 2015, a year in which oil production peaked and began to fall, and a year in which the oil and gas industry took draconian cuts to exploration budgets, natural gas production somehow continued to rise. U.S. output of marketed natural gas production hit an all-time high in February 2016 at just over 80 billion cubic feet per day (Bcf/d).
Record levels of production came just as a warm winter led to substantially lower demand than forecasters expected. With large parts of the U.S. experiencing mild winter temperatures as part of an El Nino weather pattern earlier this year, much of the excess supply was diverted into storage. But that only created another supply problem: Gas inventories rocketed to record levels.
Every year, natural gas inventories see significant seasonal changes. Demand for natural gas spikes in the winter due to heating demands, causing inventories to draw down, but they then build back up between spring and fall. However, with tepid demand this winter, record upstream production caused storage tanks to fill up. The U.S. exited the winter demand season with 2,478 billion cubic feet (Bcf) in storage, a record high for March. It is not a coincidence that spot natural gas prices hit their lowest levels in nearly two decades at just about the same time.
An extended period of low natural gas prices has forced drillers to scale back on operations. The natural gas rig count has collapsed in recent years, falling from over 900 in 2011 down to just 90 as of June 24, according to Baker Hughes.
Nevertheless, natural gas production continued to rise even as the rig count plummeted. Part of that was due to the improved drilling efficiency from the gas industry, but the bigger reason is that gas is produced in conjunction with oil. While E&Ps continued to drill thousands of new oil wells, natural gas supply continued to expand.
But, of course, oil prices plunged by more than half over the past two years. The combined effect of several years of low natural gas prices, along with the plunge in oil prices, meant that companies shelved drilling plans in spectacular fashion. The cutbacks finally started to have an effect on upstream natural gas supply in late 2015 and into early 2016. Gas production peaked at all major shale regions earlier this year, most notably in the vast Marcellus Shale, which stretches across much of Western Pennsylvania and parts of Ohio and West Virginia. Marcellus production peaked in March at 17.62 Bcf/d, and has fallen by 1 percent since then.
The fall in output for the first time in roughly a decade could mark a turning point for natural gas. Although starting from record high storage levels, the “injection season”—the period between the months of April and October when inventories typically rise—has been much slower than expected. That is partly due to falling production, but also because demand continues to rise.
Natural gas is increasingly stealing market share from coal in the electric power sector. More natural gas plants means more gas is needed to produce electricity. For the week ending on June 21, the power burn for natural gas is 10 percent higher than year-ago levels. Moreover, exports to Mexico have doubled over the past four years to 4 Bcf/d, and the inauguration of Cheniere Energy’s Sabine Pass LNG export facility is contributing to a 0.5 Bcf/d of natural gas exports.
Additionally, there are cyclical reasons that demand is up—namely, hotter weather. Weather forecasts for hot weather this summer contributed to higher spot natural gas prices in June in anticipation of elevated demands for electricity and air conditioning.
Higher demand and contracting supply are the ingredients for a much weaker injection season compared to past years. For the week ending on June 21, the U.S. added 62 Bcf into storage, much lower than the average 88 Bcf for this time of year. So while there is still a very large surplus, storage levels are rising slower than usual.
“The combination of hot weather and higher gas usage per degree of demand has been practically made-to-order for the oversupplied gas market, and has led to record power burn in June to date,” Sheetal Nasta, an analyst at RBN Energy, wrote in a June research note.
Gas price rally
“You have supply disruptions, we’ve already seen production weaken a bit this year, and we are seeing forecasts for hot weather,” Kent Bayazitoglu, an analyst at Gelber & Associates, told Bloomberg in a June 28 interview. “That’s putting fuel in the fire, adding a little support to the rally.”
Oil companies are also expected to deploy more rigs as crude prices rise, which will lead to higher associated natural gas production. The fall in production could quickly be reversed.
While natural gas prices posted impressive gains in June, there is an upper limit to a price rally, a ceiling that is likely not too much higher from current levels. Already, the industry has added 8 gas rigs back into operation, additions that took place alongside the rise in prices. Oil companies are also expected to deploy more rigs as crude prices rise, which will lead to higher associated natural gas production. The fall in production could quickly be reversed.
In addition, natural gas inventories might be building at an unusually slow pace, but because injection season started at record seasonal levels, the U.S. is still on track to set a new high of 4,161 Bcf before winter sets in at the end of the year. Just as crude oil prices will have trouble sustaining gains until storage levels are drawn down, record levels of gas sitting in storage will weigh on any price rally.