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Introduction
It is not news that U.S. natural gas prices (NG1:COM) are highly volatile. In addition to the usual cycles from overproduction to shortages in commodity markets, we are dealing with a commodity where the balance of supply and demand is so delicate that it can change dramatically even in response to single, hard-to-predict technical factors, such as the Freeport explosion last year. And, of course, natural gas price is highly weather-dependent, which apparently gives it an undeniable reputation as a widow maker.
The analysis of natural gas supply and demand dynamics is rather complicated and multifactorial also because both supply and demand are multicomponent. There is internal and external demand. Domestic demand is for power generation, for heating and for various industries, and each of these components should be analyzed separately. In turn, supply is also highly diverse. The cost of production varies greatly from basin to basin and there is also associated natural gas, which is obtained as a by-product of oil. And as the icing on the cake, there are actually many local gas markets due to transportation constraints. Of course, a real analysis to forecast the natural gas market must include an analysis of the dynamics of all these components, but the uncertainty will be quite large due to the large number of variables and their probabilistic nature.
In this article, by contrast, we will take a holistic approach and try to analyze the dependence of the price of natural gas on just one variable–how much gas is in storage. We will see how this dependence has changed in the past and try to look into the future.
Gas Prices And Gas In Storage: How It Used To Be
Below, you can see graphs of natural gas prices and storage surplus compared to the average of the previous five years. The first thing I noticed when I put these graphs together was that the words of natural gas producers’ representatives that the current surplus will dissipate sounded even more convincing to me. This is not just an abstractly rational statement from the point of view of market laws, natural gas inventories have indeed always tended towards their average value, at least in recent years. At the same time, compared to production volumes, the deficit and surplus have never looked too large.
The maximum surplus we see on the graph is produced in about a week, and the exports that have fallen due to an accident at just one LNG terminal in a few months exceed the current surplus. The market is constantly doing the delicate work of balancing itself.
As you might expect, if one compares graphs of natural gas price and surplus, it is easy to see that they are related. Price minima were reached in 2016, 2020 and 2023 almost simultaneously with the maximum surpluses. This year’s price minimum was higher than in the previous two cases, but the surplus was also slightly lower this year, so this year’s price minimum fits nicely into the series of previous price minimums.
At the same time, we see that the moderate supply deficit in 2022 coincides with much higher prices compared to previous years. To make sense of this, let’s take a look at the graph below, where prices are shown as a function of the natural gas storage surplus. While what we see is far from a perfectly smooth line, the graph clearly shows that in recent years prices have depended on the surplus in one of two patterns shown in different colors.
Until 2021, we have a flatter curve with a somewhat stronger rise in prices to $4 at the very left side of the graph when the deficit is at its maximum. Between 2021 and 2022, we have an impressive price increase to almost $10 even with moderate deficits. The difference between the two patterns is clearly visible just when there is a deficit of natural gas in storage, while when there is a surplus, prices are in the same range. Perhaps the reason is that when there is a surplus, the market pays more attention to the production cost below which the natural gas output will be drastically reduced, which will quickly bring the surplus to zero. The production cost apparently has not changed radically in recent years, in the sense that it has changed less than the statistical spread of the values on the graph. Anyway, the market is now in surplus, and we can’t tell from this graph whether the later paradigm is continuing or whether we are back to the earlier pre-LNG paradigm. There is another way to find it out, we will come back to that later.
It is important to note that although the temporal boundary between the two patterns is arbitrary to some level, in order to clearly separate the points, the border had to be drawn in 2021. In other words, well before the beginning of problems with Russian gas supplies to Europe due to the war and thus the paradigm shift that led to the emergence of the later pattern can hardly be explained solely by panic. It seems that between mid-2019, when the period of natural gas deficit in the market ended, and early 2021 when the deficit returned to the market something happened that changed the response of natural gas prices to its deficit in a big way, namely, it led to much higher prices. What exactly happened? I think the correct answer is that during this time period the amount of LNG exported from the US doubled, increasing by over 5 bcf/d. As you can see in the graph below this was the period of the fastest growth in LNG exports in history and I have not found any other events of such magnitude in the natural gas market to put forward an alternative hypothesis.
Also, from 2021 onwards, there has been a period of high prices in global LNG markets and there is a great temptation to attribute the high US natural gas prices to the impact of external prices due to the globalization of the natural gas market. In practice, it is not that simple. A very common and reasonable counterargument is that if LNG terminals are operating at full capacity for the U.S. natural gas market, it doesn’t matter how much natural gas costs in Europe or Asia- it won’t be possible to increase exports. But first of all, although I’m not an expert, I’ll allow myself to speculate on the following topic. From my observations of export volumes, I can assume that LNG terminals have some freedom in how much gas to deliver at a given moment— a bit more or a bit less. The monthly export high as seen in the graph above was reached in April of this year at 12,6 bcf/d. This is quite significantly higher than in many of the recent months when Freeport was either already operating or still operating, i.e. nominal liquefaction capacity was the same as it is now. And all this time it was thought that export capacity was fully utilized. The market may believe that higher prices on global markets can lead to a 1 bcf/d increase in supply (a value that seems reasonable based on the chart below), which is not a negligible amount. Such an increase in exports alone would bring the entire current surplus to zero in about 7 months. Second, whether or not the global market’s impact on the U.S. is justified, it is definitely there, and has been for a number of years. Will it suddenly come to an end, given the fact that in the coming years we will see an increase in LNG exports and, as a consequence, a move towards the already undeniable globalization of the natural gas market? I doubt it.
What Futures Tell Us
Importantly, the futures market also seems to believe that prices will continue to follow the trajectory from the later pattern, and thus we continue to be in it. As shown in the graph below, starting in 2025 the futures market predicts average annual prices just above $4. It makes sense that the futures market assumes that there will be a zero deficit on average for each of these years, because the market is effectively seeking balance.
If so, then futures prices are consistent with the later pattern. The price-vs-surplus graph shows that natural gas prices near zero surplus are clustered around $4 for the second pattern, while the corresponding prices for the first are around $3.
Conclusion
The main conclusion of this article is that during the next period of natural gas deficit, prices are likely to rise much more than the market currently expects. How far we are from that period– depends on many factors, those are described in the introduction. The main one is the weather. In addition, such a forecast itself implies an increase in price volatility, not a decrease. Therefore, buying decaying financial instruments like UNG and BOIL does not seem like a good idea to me, despite my bullish position on natural gas.
I think it is better to buy shares of natural gas producers. However, the attention should be paid to their financial strength and their low production costs, which can ensure that the company will safely survive the period of low prices, if it lasts for some time. I also think it is important to pay attention to how a company hedges natural gas prices. The less hedges, the more upside in my opinion. For this reason, if I could only own shares of one natural gas producer, I would choose Antero Resources (AR). But that is a pretty risky approach. Do your own due diligence.