Published on January 7, 2022
As we transition to the heating season and enter the period when the demand for natural gas is typically at its highest and its price at its most volatile, it may be useful to bear in mind: (1) what are the set of circumstances that got us here, and (2) how long are they likely to persist and keep upward pressure on prices?
As a reference point, the US gas spot price reached $6.37 per MMBtu in early October 2021. That’s $4.45 (+232%) higher than a year ago. When you back out the impacts of Hurricane IDA, prices for the first half of September 2021 were $2.81 (57%) higher than a year ago.
Recent financial practices in the oil and gas industry were characterized by aggressive drilling exploration and production activities with little regard for either the expense or achieving return on investment. This had the effect of flooding the market with product, culminating with a significant low in natural gas prices in June 2020, coinciding with the pandemic economic shutdown. The lesson learned by the investors whose money was funding the exploration and production (E&P) activities, and the banks who were aggressively lending to this, was to put away the checkbook and impose some discipline on their partners.
From this we draw the conclusion that the sudden reversal of investor/bank sentiment towards underwriting the industry had its origins in the sharp reduction in consumption occasioned by the pandemic. That, coupled with the cash burn, paused the rapid gains in bringing gas to market.
In the same timeframe, other factors emerged to help push up US demand for gas. An unusually hot summer in 2021 in the US boosted demand and the sizeable growth of a new market for US-originated natural gas (namely, exports to Europe and Asia) increased demand.
In just a year’s time, gas exports in the form of LNG have increased from 4.5 bcf/day in July 2020 to more than 12 bcf/day in August 2021. This has caused gas inventories to be depleted and pulled up prices. In addition, with our somewhat new customer, Europe, a severe natural gas shortage has emerged.
A closer look at why their price of natural gas has soared to over $35/MMBtu (US equivalent) provides important lessons for how the US should proceed:
- Europe drained its natural gas storage during the colder-than-normal Covid winter of 2020-2021.
- Storage refill during the 2021 summer was off pace of expectations due to reduced imports from (Europe depends on imports for 77% of its annual natural gas needs).
- European-wide mandates to phase out coal plants over the past 10 years left it without dispatchable-ready plants to take up the slack created by the natural gas shortages. On top of this, record high carbon prices (which are mandated to be tacked onto the coal price) made moving to a coal burn less attractive because it pushed up the cost of switching to
- Wind generation, which has grown significantly as a source of power for Europe, was stilled by an absence of wind coincident with the other impacts described
These pressures notwithstanding, the lure of even greater premiums for US LNG in Asia where buyers are paying $55/MMBtu is creating pull on the US Henry Hub price. By and large, the US prices are the cheapest in the world and as foreign markets scamper to fill storage, we will continue to feel the influence of these offshore prices. With delivered prices well north of $55/MMBtu the netback (profit) to US sellers is in the $25/$26 MMBtu range.
In short, the US natural gas market is no longer ring-fenced by North America’s land mass.
Just to give some further perspective on the cash and carry trade, the number of LNG vessels transiting the Panama Canal have surged from a low of 163 in 2017 to 498 (thru August) in 2021.
The arrival of US gas on to the world stage comes at an important juncture. The UN Climate Conference (COP26) was held in Scotland, November 2021, and the expectation by many market participants was that natural gas would continue to emerge as the consensus fuel source for the world’s energy transition. Anyone on the producing end or inhabiting any of the many business process steps between extraction and final end use, this could be very good news for one’s P&L. However, anyone at the point of final sale, can expect prices that reflect the new, zig-zag journey of added costs accumulated along the way.
In media coverage for COP26, there were high expectations that countries would commit to policies that further the energy transition through exiting use of fuels with the highest carbon content and adopting in their place fuels with lesser or zero carbon content. Countries such as India, China, and South Africa, where the incumbent fuels of oil and coal are dominant, will be incentivized to convert to systems that use natural gas as a primary fuel. These are not small countries and are among the largest in this category. The barriers encountered by these countries to accelerate their adoption of gas as a transition fuel will be diminished by a coordinated, world-wide effort to make gas accessible and plentiful.
In addition to spurring the expanded use of gas, actions emanating from COP26 will likely include adoption of a carbon pricing model over time to reflect the (financial) environmental externality associated with using carbon-content fuels. Hence, coal, oil, and, yes gas will all be price-penalized for their carbon content to discourage or diminish their roles as primary fuel sources.
I bring all this to your attention because the implications for future pricing of natural gas are significant. A structural change in the cost of this fuel to a world where its consumption may grow by leaps and bounds is something our markets should be preparing for.
Availability should not be a concern. North American reserves are abundant as are those in the former Soviet Union and throughout the Middle East. However, combine the abundance of supplies in the US and Canada with the transit-friendly infrastructure enabling delivery to export markets, and there is plenty of evidence that we may be in for a prolonged period of higher prices.