National Post (National Edition)
Why the natural gas price rally has legs.
The natural gas price rally this year has been impressive, to say the least, and seems to have sustainability. Buoyed by strong demand and tight supply, natural gas futures for the fir st expiring contract settlement climbed to US$3.82 per mmbtu in July, the highest since late 2018. Investors, however, do not seem to be convinced the rally can be sustained: every bull market requires a healthy dose of skepticism.
The market is indeed in backwardation, perhaps influenced by the United States Energy Information Administration's forecast of lower prices next year. Like the EIA, we're bullish about 2022 production, although we're less convinced those new supplies will be enough to fulfil demand growth. Since hitting a multi-decade trough last year, courtesy of the pandemic, U.S. natural gas prices have more than doubled.
A recovering economy coupled with extreme temperatures have caused electricity consumption in the first half of 2021 to jump four per cent compared to the same period last year, fuelling an increase in natural gas demand by power producers. Supply has also been tight, thanks to flattening production and record exports as American natural gas producers look to benefit from higher global prices.
There are doubts out there, however, about whether the natural gas price rally can be sustained. The EIA expects prices (Henry Hub spot) to drop next year as supply rises faster than demand. That view seems to be shared by investors based on backwardation in natural gas markets, with the price of the first expiring contract topping that of a 12-month expiring contract by the most since 2018.
This perhaps reinforces the view that natural gas has overshot its outperformance of oil in this commodity upcycle. But a closer look reveals that the oil-togas price ratio, despite the recent decline, is roughly in line with the average of the past five years. As such, rather than overshooting, natural gas seems to have caught up with oil after underperforming earlier.
Like the EIA, we're bullish about 2022 natural gas production, which is slated to pick up after a flat 2021 so far. Rising commodity prices this year should indeed incent producers of both natural gas and oil (i.e., including those that produce gas from oil-directed rigs). On its own, a ramp-up in output is negative for prices. But we're less convinced than the EIA that those new supplies will be enough to fulfil demand growth.
For one, storage will need to be replenished after inventory draws stemming from a brutal winter in many parts of the U.S. and a scorching summer, both of which pushed up demand for electricity and, hence, source fuels such as natural gas. At the end of July, inventories (what the EIA calls “Working Underground Storage”) were roughly 2,800 billion cubic feet (bcf). That's not only well under last year's levels, but also about fiveper-cent below the five-year average for this time of year. Net weekly injections into storage averaged 55 bcf over the AprilJuly period, also well below the five-year average.
Even if injections manage to pick up and match the five-year average of 59 bcf per week for the rest of refill season, inventories would be barely above 3,500 bcf at the end of October, or sixper-cent lower than the five-year average for that time of year. In other words, natural gas bears should either hope injections into storage from August through October significantly surpass the five-year average or pray for both a quiet hurricane season and a mild winter.
The trend toward decarbonization is also bullish for natural gas. You just don't move from coal to solar panels in one fell swoop. Natural gas obviously has a carbon footprint, but it is considered by many a “bridge fuel” on the road to eventually reaching the objective of net-zero emissions. Over the near to medium term, natural gas is set to displace fossil fuels such as coal and petroleum, which have even larger carbon footprints.
We're already in the midst of such displacement in electricity generation. Despite stagnating U.S. electricity production over the past 15 years, the share of natural gas in electricity generation has more than doubled to 40 per cent. Natural gas usage in electricity generation is likely to moderate later this year amid rising prices (which should encourage some producers to switch to lower-cost fuels such as coal), but climate-change considerations ensure it will remain a crucial part of America's power system for years to come.
A recent study by Columbia University's Center on Global Energy Policy found that: “... investing more in the domestic natural gas pipeline network could help the US reach net-zero emission goals more quickly and cheaply.”
The bottom line: The outlook for U.S. natural gas looks positive despite a market in backwardation. We're encouraged by relatively low inventories, high demand for power generation and solid exports. Moreover, prices (currently a little more than US$4per mmbtu) have yet to hit levels that are going to entice new production right away. Output is still expected to rise next year after a largely flat 2021, although it's unclear whether those new supplies will be enough to fulfil demand growth amid what is expected to be a solid economic expansion not just in the U.S. but globally as well (which will support U.S. exports and eat into domestic natural gas supply).
What does this all mean for investors? If we're right about the resilience of natural gas prices, equities linked to U.S. producers of natural gas and liquefied natural gas (LNG), some of which have lagged the price rally, stand to benefit. Within the developed world, global equity investors should note that the countries with the highest proven reserves of natural gas include the U.S. (in the top five), Canada and Norway (top 20) and Australia (top 30). As far as LNG export volumes are concerned, the U.S. and Australia are atop the global list as well.