Natural gas prices climbed to their highest level in more than a year in mid-October amid falling supply and rising demand. In the short-term, those trends are likely continue, which could mean that the era of cheap gas is nearing an end. Spot prices have dropped slightly from those highs thanks to unseasonably warm weather, but futures for 2017 prices have just reached a 16-month high as hedge funds see demand outpacing supply next year.
Natural gas prices have been low for the better part of a decade, due to the wave of new supply that came online as a result of the fracking boom. Production continued to climb year after year and, aside from the unusually cold winter in 2014, natural gas prices have mostly traded below $4 per million Btu (MMBtu) for the past five years.
It is difficult to overstate the impact that cheap natural gas has had on the American economy, fueling a wave of investments in petrochemical plants, processing facilities, and gas-fired power plants. But it is unclear that gas trading as low as $2 to $3 per MMBtu, as it has for several years, is sustainable. Supply is falling and demand is expected to steadily rise. For the next few years at least, it appears increasingly likely that natural gas prices will not return to the low levels that the U.S. experienced for much of the past half-decade.
Gas supply contracting
Despite the crashing rig count over that five year period, production climbed without interruption, hitting a record high earlier this year.
The shale gas revolution unleashed a wave of gas supply on the U.S., crashing Henry Hub prices in the process. But drilling became so efficient that production continued to climb even as rig counts fell. The U.S. natural gas rig count crashed from over 900 in early 2011 down to just over 100 by February 2016. Despite the crash, production climbed without interruption, hitting a record high earlier this year.
That achievement was made possible by improved drilling techniques, a familiar story in the shale patch. Exploration companies drilled longer laterals, used more water, more sand, and drilled more wells per well pad. They found the sweet spots as they learned more about shale formations.
But some of the increases in gas production came because natural gas is produced in association with oil. The same learning-by-doing trend unfolded in the U.S. oil patch as well, and high oil prices between 2010 and 2014 pushed more drillers to focus on oil and liquids-rich plays. Still, natural gas flowed from these projects as well.
The collapse of oil prices and the dearth of drilling activity for both oil and gas finally led to a peak and decline in natural gas production beginning in February 2016. Gross production hit a peak at just over 92 billion cubic feet per day (Bcf/d) in February, and dropped by 5 percent to 87.4 Bcf/d by July, the latest month for which data is available. Gas output is now at its lowest level in two years and the declines this year are the sharpest since the financial crisis in 2008-2009.
Cheap gas spurred investment in all sorts of industrial products in which gas is used as a feedstock. The U.S. has also seen utilities break ground on a wave of gas-fired power plants over the past few years. On top of that, existing power plants burning natural gas have been used at much higher rates, to the detriment of coal and nuclear power.
Altogether, the U.S. has seen a dramatic rise in natural gas demand–up more than 13 percent since 2010. As John Kemp of Reuters puts it, the U.S. is seeing a “structural increase in gas demand with more gas-fired power stations operating more hours per year and consuming record volumes of gas.” The U.S. has added 25 gigawatts (GW) of new gas-fired electrical capacity since 2012, and another 11.5 GW will be added by the end of next year, which will take total gas-fired capacity to 459 GW. The nature of natural gas consumption is very much seasonal, however, with peaks in the winter months and valleys between March and October. But the summer peaks are growing higher, and the low points are not quite as low as they used to be.
Record storage suddenly disappears
It was less than a year ago that the U.S. had record levels of natural gas sitting in storage. In November 2015, high and rising production ensured the U.S. entered the winter season with abundant supplies, as inventories topped 4,000 Bcf, an all-time record. But the glut worsened due to a warm winter, which led to much softer-than-expected demand and a below-average drawdown in stocks. By March, the U.S. left the drawdown season with nearly 2,500 Bcf sitting in storage, a whopping 50 percent more than the running five-year average. That threatened to crush natural gas prices for years to come as inventories promised to build up in the ensuing March to October “injection season.” Henry Hub prices dropped to an eye-watering $1.50/MMBtu in March.
But natural gas markets are fickle. Upstream production has since declined by 5 percent, and demand continues its upward trajectory. That has erased much of the glut in just a few short months. By mid-October, gas stocks stood at 3,759 Bcf, just 200 Bcf above the five-year average, or about 5 percent. In other words, the glut is mostly over, and gas storage levels are back to average levels. Unlike in the oil market, in which the inventory overhang could take years to work through, the U.S. natural gas market is more or less back to balance.
Cheap gas was temporary
The sudden and unexpected tightening of natural gas markets has pushed up prices. Henry Hub spot prices are up to roughly $3.20/MMBtu, up more than 100 percent from the March low point and up 15 percent since September. Looking forward, the market could grow tighter still. Supply is still falling–the EIA predicts the major shale gas regions in the U.S. will lose 178 million cubic feet per day in November. And, of course, demand continues to rise with new power plants coming online and LNG export terminals starting up. Also, the U.S. is about to enter winter, and a La Nina weather event could cause temperatures to drop, which will cause sharper drawdowns in inventories, potentially pushing stocks to below average levels by the end of the first quarter in 2017.
To be sure, the upstream sector is showing some signs of life. The U.S. saw 11 natural gas rigs added for the week ending on October 14, the largest increase in years. Prices above $3/MMBtu are bringing some drillers back. Perhaps a more important trend is the uptick in oil drilling, which could bring forth more gas production as well. For that exact reason, natural gas production continues to rise in the Permian Basin in West Texas, which continues to thrive during the oil price downturn. Gas production in the Permian has increased 10 percent so far this year and the EIA expects that to continue in the near-term.
But that might not be enough to arrest declines in the U.S. overall. Falling supply and rising demand are tightening gas markets, which could mean that sub-$3/MMBtu gas could be a thing of the past.