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Sunday December 17, 2017

Natural gas prices averaged a little more than $2.50 per mmBtu (million British Thermal Units) in 2016. Those days are over. Prices will average at least $3.50 to $4.00 in 2017.

Prices have more than doubled since March 2016 but gas is still under-valued. Supply is tight because demand and exports have grown and shale gas production has declined.

In April of last year, I wrote that natural gas prices should double and they did. Henry Hub spot prices increased 2 1/2 times from $1.49 to $3.70 per mmBtu and NYMEX futures prices doubled from $1.64 to $3.30 per (Figure 1).

Natural Gas Prices Have More Than Doubled Since March 2016 The Days of 2.50 Gas Are Gone 1024x742

Figure 1. Natural Gas Prices Have More Than Doubled Since March 2016: The Days of $250 Gas Are Gone. Source: EIA and Labyrinth Consulting Services, Inc.

Nevertheless, gas prices are still too low. Storage was at record high levels throughout 2016 reaching 4.1 Tcf (Trillion cubic feet) and 84% of working capacity in mid-December. Storage has fallen 1.1 Tcf in the last month to 61% of capacity. That is below the 5-year average (pink, dashed line in Figure 2).

Gas Storage Levels Have Fallen 1.1 Tcf To Below the 5-Year Average

Figure 2. Gas Storage Levels Have Fallen 1.1 Tcf To Below the 5-Year Average. Source: EIA and Labyrinth Consulting Services, Inc.

Comparative inventory (C.I.) trends are the best indicators of gas price. These compare current storage to a moving average of levels for the same date over that last 5 years and correlate negatively with spot prices (Figure 3). C.I. fell 120% from May to December 2016 and gas prices doubled.

Comparative Inventories Have Fallen Sharply Since May

Figure 3. Comparative Inventories Have Fallen Sharply Since May. Source: EIA and Labyrinth Consulting Services, Inc.

There are occasional short-lived excursions from the correlation. These typically occur when the market believes there is sufficient supply for the winter heating season in September or October. The market over-shoots with lower prices that are later corrected upward.

The November 2016 price drop shown in Figure 3 is an example of this phenomenon that occurred outside of the normal September-October pattern. A similar price drop began in January 2017.

Figure 4 shows the November and January price drops as departures from comparative inventory vs. spot price trend lines.* The current trend line (May 2016 - January 2017 in red) closely resembles trends for periods when gas prices were $4.00 per mmBtu or higher (August 2011 - March 2013 in orange and March 2013 - March 2014 in purple).

Natural Gas Is Undervalued By $0.50 - $1.00-mmBtu

Figure 4. Natural Gas Is Undervalued By $0.50 - $1.00/mmBtu. Yield curves show relevant trend lines for current natural gas prices. Source: EIA and Labyrinth Consulting Services, Inc.

Recent price drops partly reflect market expectation of increased gas production in the Marcellus Shale play because of new 2017 pipeline capacity. They also suggest that the market anticipates greater tight oil and associated gas production following OPEC production cuts.

Figure 4 suggests that current gas prices are under-valued and should be at least $3.75 and probably closer to $4.00 instead of $3.27/mmBtu, last week's average spot price.

Supply and demand fundamentals also support higher prices. Gas production has been declining since February 2016. At the same time, net imports are decreasing as pipeline and LNG exports increase.

Shale gas production is declining and conventional gas has been in terminal decline for the past 15 years. As a result, the supply surplus that has existed since December 2014 has disappeared and a supply deficit began in January (Figure 5).

Natural Gas Supply Deficit In January 2017

Figure 5. Natural Gas Supply Deficit in January 2017. Source: EIA January 2017 STEO and Labyrinth Consulting Services, Inc.

During the last supply deficit from December 2012 to November 2014, Henry Hub spot prices averaged $4.05 per mmBtu. NYMEX futures prices reached $3.93 in late December 2016 before closing at $3.20 last week. Both spot and futures prices should return to $3.75 or higher once the market recognizes the reality of tighter gas supply.

Shale gas production has declined almost 1 Bcf per day since August 2016 and all shale gas plays are in decline (Figure 6).

Shale gas production has declined 1 Bcfd since August 2016 1024x745

Figure 6. Shale gas production has declined 1 Bcfd since August 2016. Source: EIA and Labyrinth Consulting Services, Inc.

Only the Marcellus and core Utica plays break even at $4 gas prices. The Marcellus has stopped growing and more pipeline capacity to better-priced markets won't happen as quickly as some analysts believe. Although the Utica play has growth potential, it will be spread over several years and will be largely cancelled by increased exports.

Shale gas magical thinking remains strong but the paradigm of infinite, cheap supply is no longer working. There is now too much demand between power consumption and exports to keep up with declining production.

Once decline begins, it is almost impossible to turn around short of a massive drilling campaign. The requisite capital and public support are simply not there.

That means that prices will increase. Enough additional drilling will become marginally profitable to keep natural gas affordable but it is unlikely the U.S. will return to a supply surplus any time soon. The exuberant days of cheap, abundant natural gas are over.

*Developed by my colleague J. M. Bodell who has taught me everything that I know about comparative inventories.

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