I’ve been getting a ton of questions lately about the US natural gas market and, in particular, the near 70% plunge in front-month natgas futures since last summer’s peak.
Natural gas is notorious for its volatility and, frankly, its unpredictability. In my experience, one key to trading the commodity is to look for opportunities where “the crowd” is leaning bullish or bearish, yet, there are specific catalysts that could emerge to change that consensus view. Such sentiment set-ups can lead to the dramatic reversals so characteristic of the gas market.
And, while that process might sound subjective, I’ll highlight one indicator, unique to commodity markets, that can help quantify market sentiment.
Let’s start with what’s driving the natural gas market right now. The most important, and widely watched, fundamental for gas is storage:
Source: Bloomberg
This chart shows current US natural gas in storage (blue line) since the beginning of 2022 compared to the 7-year seasonal average.
Two points jump out:
First, since the beginning of last year, US natural gas in storage has been below the seasonal norm – last summer, hot weather across much of the US brought strong gas demand and tight supply, sending prices sharply higher.
Second, there’s a quirk in the most recent data on US gas storage – in the first week of January, US gas storage rose 11 billion cubic feet, which is extremely unusual this time of year. And in the second week of the year, storage fell 82 bcf, which is a smaller-than-normal seasonal drop.
In winter, heating demand – either direct use of gas to heat homes or electric heat powered by gas-fired power plants – tends to drive a rapid drawdown in gas storage levels. The months of January and February are the heart of what’s known as gas withdrawal season.
The reason for last week’s storage build, and this week’s modest withdrawal, is simple: The weather.
Temperatures across the US have been unseasonably mild to start the New Year, and the National Oceanic and Atmospheric Administration (NOAA) issued a medium-term outlook for the 2022-23 winter season back in December showing much of the country with above-average temperatures through March:
Source: NOAA
As you can see from the map above, much of the eastern US, including New England, is shaded orange-to-red, indicating well above-average probability of warm weather for the first three months of 2023. These are regions that historically drive strong demand for natural gas in the winter months.
Bottom Line: Mild weather is driving lower-than-normal winter seasonal storage drawdowns; however, US gas storage remains below the long-term average for this time of year.
The Supply Side
Let’s flip over and look at the supply side of the equation:
Source: Bloomberg
When it comes to gauging trends in US gas production – the supply side – I like to watch output from the Haynesville shale most closely.
That’s because the Haynesville is a large shale field located in eastern Texas, extending to the east through much of central Louisiana. Geographically, the field is located close to the US Gulf Coast, home to a number of gas-intensive industries like oil refining and fertilizer production as well as the largest concentration of US liquefied natural gas (LNG) export terminals.
Since Haynesville shale output doesn’t need to be transported long distances via pipeline, production from the region tends to be more sensitive to near-term gas demand rather than pipeline capacity bottlenecks.
Also, Haynesville is a low-cost play, but it’s higher cost than the Marcellus in Appalachia, and it’s primarily dry gas (gas that doesn’t have much natural gas liquids content). So, Haynesville output tends to be more sensitive to natural gas prices, rather than the value of NGLs like propane and butane.
Finally, because gas in the region has a higher breakeven cost, producers ramp up drilling activity when gas prices are high and rising, but are relatively quick to reduce output, or moderate planned expansion, when prices fall.
Bloomberg publishes a daily estimate of Haynesville gas production that’s based on pipeline flows – the daily data is very noisy, so I like to watch the 7-day and 30-day moving averages pictured in my chart above.
As you can see, this data series shows Haynesville gas production soaring to new highs early this year on a 7-day average basis and recovering to near last autumn’s highs on a 30-day average basis.
Of course, for much of 2022, US gas prices were high, reaching levels we haven’t seen since 2008 in August. As a result, producers in the Haynesville increased production steadily last year.
Indeed, this is perhaps the most important factor behind the bearish view I held on US gas prices for much of last year. My view was the longer prices remained above $5/MMBtu or so, the more supply we could expect in the pipeline.
Ultimately rising supply is what brings down prices and that’s exactly what’s played out over the past 5 months.
Also, we felt, and still feel, the market became too enamored with the US LNG export story last year.
The LNG argument is pretty simple – US gas prices trade at a significant price discount to prices in Europe, making it economically advantageous for US producers to ship more gas to the EU. From Europe’s standpoint, replacing Russian natural gas supply, imports that are no longer viable or politically palatable, with gas from the US appears to be an easy way to enhance energy security.
The problem is that exporting LNG requires liquefaction terminals in the US and such facilities take years to permit and build. US LNG export capacity was already maxed out for much of 2022 and no significant new export capacity is slated to be completed until the second half of 2024.
Thus, while the Russian invasion clearly made US LNG supply more attractive in Europe, and helped ensure strong exports through last year, the incremental impact on US gas demand was minor given physical export capacity restrictions:
Source: Bloomberg
As you can see, while US exports of LNG have ramped up significantly since 2016, growth actually hit a wall in 2022 even though the spike in EU gas prices rendered US exports more price competitive than ever. Indeed, US LNG exports in October 2022, the last month for which we have data, were lower than in December 2021.
Adding to LNG export headaches was a fire at the Freeport LNG export facility in Texas back on June 8, 2022, which forced the plant to be shut for the remainder of the year, hampering the LNG export supply release valve.
Recently, reports suggest gas has started to flow to Freeport LNG for liquefaction, and the facility appears on track to restart late this month or in February pending some regulatory approvals.
I was early in my bearish call on gas last year, and hot summer weather delayed the move, but gas prices have now fallen back to Earth.
In many ways, the situation today is a mirror image of the set-up last summer – with prices plummeting, and well below $4/MMBtu, I suspect it’s only a matter of time before US gas supply growth moderates or even rolls over. At prices around $3/MMBtu to $3.50/MMBtu, a growing swathe of US gas production just isn’t profitable to produce, so I’d be surprised if gas can remain below that level for long without a meaningful drop in supply.
We’re already seeing some signs of this – the Haynesville rig count is down to 68 active rigs from 72 rigs in late December and the overall US active gas rig count is at 150, down from a high of 166 rigs in early September.
At the same time, demand trends are fickle and risks are skewed to the upside for gas.
Right now, the market is focused on warm weather and consequent weak demand; however, there’s always significant probability of a cold snap this time of year that could reverse that picture. And, in just a few months, market participants will start looking ahead to the potential for another warm summer that could cause a surge in summer cooling demand.
And then there’s Freeport LNG, which is due for restart in the next few weeks, something that would increase demand.
As I noted at the start of this issue, natural gas prices are notoriously volatile and the only way to trade gas is to assess the balance of risks – in other words, is the risk of a big “spike” to the upside higher or lower than a big spike to the downside?
Much of that question is a function of market positioning:
Source: Bloomberg
This chart is based on data from the Commitment of Traders Report released every Friday afternoon by the Commodity Futures Trading Commission (CFTC).
It shows the total net futures position held by speculators (managed money traders) in US-traded Henry Hub Natural gas futures. As you can see, such speculators are now net short more than 87,000 natural gas futures contracts.
Let’s put that into historical context – the lower pane of my chart shows the Z-Score of the current position in natgas futures relative to the past 104 weeks (2 years). As you can see, the current position is almost 1.6 standard deviations below the 2-year average.
Put simply, speculators have an historically large net short position in gas, betting on lower US natural gas futures prices.
I believe this suggests the pendulum of sentiment on US natural gas prices has swung from unsustainably bullish at times last year to overly bearish now in early 2023.
With market positioning so bearish, and so many shorts sitting on sizable profits in gas, even a modest whiff of positive news could ignite a powerful wave of short-covering in the futures market as those heavily net short speculators seek to book profits on their positions by buying to cover gas futures.
The truth is that we can’t predict with any degree of accuracy where gas prices will be in a week or two – it’s possible we’ll see spikes below $3/MMBtu in the next month or so. The reason the short-term is so unpredictable is that it’s largely a function of weather and it’s the understatement of the century to say weather conditions are tough to predict with any degree of accuracy, especially outside of the next few days.
However, sentiment on gas is terrible, traders are already heavily short, and not all the news is bad – after all, even with close-to-average weather for the rest of this winter heating season, US gas storage will likely end withdrawal season pretty close to the long-term average.
Yes, gas production remains strong; however, gas prices were over $4/MMBtu until very recently. Just consider: January 5th was the first close below $4 and December 28th was the first close below $5/MMBtu this cycle.
So, producers haven’t had time to react and reset – we suspect we’ll see and hear more talk of flat-to-lower US supply in coming weeks.
If all these potential bullish catalysts wither, gas prices could fall a bit more, perhaps to $2.75/MMBtu from $3.30 currently; however on any hint of good news, it’s not hard to imagine gas near $5/MMBtu in short order. That’s a solid reward-to-risk set-up in my view.
I do believe this recent sell-off in gas has created some particularly compelling opportunities in stocks of US-based natural gas producers, which is something I’ll be covering in more depth in the complimentary webinar I’ll be hosting with my friend and colleague, Roger Conrad, on February 2nd at 2 PM Eastern. You can register to attend by tapping here.
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DISCLAIMER: This article is not investment advice and represents the opinions of its author, Elliott Gue. The Free Market Speculator is NOT a securities broker/dealer or an investment advisor. You are responsible for your own investment decisions. All information contained in our newsletters and posts should be independently verified with the companies mentioned, and readers should always conduct their own research and due diligence and consider obtaining professional advice before making any investment decision.