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What Could Be Trigger for Gas Industry's "Reset Button"?

January 22, 2016 | By Luke Larsen

It was just more than a month ago that the CME/NYMEX Henry Hub prompt-month natural gas futures traded down to lows not seen in well over a decade. The steeply contangoed January futures touched below $1.70/MMBtu on Dec. 18.

This was the trade community throwing in the towel as the industry embarked upon a two-week period of reduced commercial loads around the holidays. The timing of this latest drop was perhaps facilitated by lack of investor interest, with virtually no serious heating requirements across the country at year end.

The futures market didn’t stick around those low levels that long. The following week brought profit-taking and year-end position covering; we saw some buying pressure that pushed up the forward prices significantly. 

But it was a strange time. The rally occurred simulataneously with the cash market reaching new lows across the eastern consuming region. Northeast city gates bottomed out during the Christmas holiday as prices in New England, New York and New Jersey all fell below $1/MMBtu for multiple days. 

This significant separation of cash to futures was forecasted by PointLogic Energy analysts and detailed to clients several days prior to the actual event.

Daily Cash & Prompt Futures Settlements
Source: PointLogic Energy

The chart above displays the disconnect that occurred during the period of 12/23 to 12/28 with temperatures in New York City approaching 70 degrees. This left little market share for those spot producers/shippers to compete, resulting in record winter delivered cash price lows.

As the market returned from the extended holiday, they found that Monday morning (12/28) brought about the realization this heating season was far from over. A wild winter system pushed across the Rockies, deep into the Southwest producing corridor and into the Midcontinent bringing heavy snow, flooding and power outages. A freeze-off reduced the gas available for market by roughly 3 billion cubic feet per day (Bcf/d). 

Below (courtesy of the NWC satellite imagery) are before and after snapshots of the event.

 

*The U.S. Snow cover levels on 12/24/15;

National Water Center, NOAA

Source: National Water Center, NOAA

 

*And the U.S. Snow cover on 12/28/15;

Snow Depth NOAA

Source: National Water Center, NOAA 

It shouldn’t surprise anyone that the relatively modest weather would drive price higher. This was confirmed with futures eventually moving back to an intraday high of $2.495 on the February contract at the end of the first week of January. This rally of more than 40% from the lows of mid-December allowed the market to reset and reconsider.

By now we have confirmed that the United States does still burn more than it produces on a day-to-day basis during peak periods. Historically, when one would look to evaluate the price shape of each winter strip, January would generate the highest price, and December would be a distant third behind February.

PointLogic Energy’s expected Residential and Commercial demand for those respective periods (on a month to date basis) accentuates that fact, as shown in the graph below.

MTD Res/Com Demand Bcf/d
Source: PointLogic Energy

The current month has outpaced December Res/Com burn by an average of more than 17 Bcf/d. So while we do reflect a significantly higher level of consumption this month, January 2016 by itself remains nothing special. Demand has still come in lower than last year, which has allowed for additional storage surplus to build. 

It still pales significantly to the infamous January of 2014. This "new world" curve shape should not be considered a localized event. An investigation of the forward curve even several years out has each December contract discounted to the following March contract.

These fairly obvious facts have already grounded the current rally. 

The Next Major Move 

So now the industry sits at a point of market price demarcation, awaiting the next round of fundamentals to prompt the next major move.

Will the financial pain on gas-only producers result in production cutbacks? Will another price rebound occur, such as that experienced during New Year’s wee? Or will we be limited similar to the partial pullback that occurred after New Year's when conditions improved consistently cold weather seems out of reach?

What will be the natural gas industry’s next potential "reset button" that might remedy the supply/price situation?

As of just recently, February natural gas futures have been wobbling between the range of $2.00 to $2.20. What makes this particular price level so remarkable is that it isn’t occurring during a seasonal shoulder period. Of concern to producers is that the low prices are existing when gas prices historically would hit their uppermost peaks. 

In December 2014, which was also one of the warmest Decembers on record, gas futures prices were ranging between $3.50 and $4.00.

Over the course of this past July and August, when gas futures prices were trading frequently in the $2.80 to $3.00 area (and thought to be "too low" at the time),  several large U.S natural gas producers mentioned on their quarterly earnings calls their intention to wait until this winter to begin hedging some of their production at seasonally higher prices. Unfortunately, this strategy seriously back-fired. 

Time to Hit the "Reset Button"?

"Reset button" is a widely used term to express how an unsolvable situation can be quickly and effectively remedied in relatively short order. The gas industry would probably agree that it would be nice if it could remedy its oversupply problem just by pressing a reset button.

However, this reset wouldn’t be pleasant to experience. The critical reset button for an industry that keeps drilling for more and more natural gas would be a production pullback that would finally halt the steep and painful drop in gas prices.

Possibly, that button may be pressed in 2016. Major media and analysts have been warning a rash of bankruptcies may be looming.

With gas futures prices now trading at near historic lows, it's obvious that some of the largest (and smallest) gas producer companies in the market are struggling to keep their heads above water. 

Retired natural gas hedge fund mogul of Centaurus Capital, John Arnold, commented via Twitter in early December that the threat of bankruptcies is ever closer to reality. “With few hedges for '16, half of the U.S. energy industry will be bankrupt in 6 months with prices at these levels. OPEC definitely smells blood," Arnold tweeted.

How low can it go?

So how did the gas market get to such a painful place, and how low can prices go from current levels if winter demand in the eastern half of the U.S. exits the market again for an extended time during February? 

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Currently, PointLogic Energy natural gas wellhead production estimates have consistently hovered between about 80 Bcf/d and 82 Bcf/d each week for most of 2015. This is extraordinarily robust, considering the immensely bearish state of affairs at hand for the industry. 

But a chief reason behind why gas supply is so abundant is fairly eye-opening. Ever since the gold rush to shale gas production via fracking ramped up around 2008, the utilization of massive credit supported an onslaught of production projects. This, of course, has created the mother of all negative price loops.

For gas producers to presently service giant debt loads in a declining price environment, more revenue is required. About the only way for natural gas producers to boost revenue is to increase drilling and produce even more molecules,despite the already glutted market. This then decreases natural gas prices, while also devaluing the value of underground reserves. 

The now-lower prices don’t generate enough revenue to pay the bills. Therefore, even greater production efforts are required -- even if it means collecting outrageously low prices for the gas commodity.

Because prices are trading at such historically low levels, virtually no gas producer is 100% hedged. It doesn’t take long to see how this sort of negative-loop situation can turn into a death-spiral for some companies. Especially so if banks and investment companies become more reluctant to lend to the oil and gas industry.

“When a producer isn’t hedged, it complicates the matter in terms of security on loans, therefore new projects and completion projects will eventually slow due to the limited availability of credit capital resources,” said Ray Pereira, Houston investment banker. “And in fact, many investment firms are not making any new loans at all and are only maintaining what they already have.”

Natural gas prices are also sensitive to how much supply is available in U.S. underground gas storage facilities. The gas storage situation became acute for gas prices this past November when injection season totals topped 4 Tcf, marking new all-time highs.

As the gas industry entered the fall, the only hope for the industry was the 2015-16 winter.

What will a warm winter do?

However, those hoping that a cold winter would burn off excess gas supply were sorely disappointed. The month of December, from a weather-demand perspective, was considered to be the pivot point or make-or-break catalyst for gas futures prices. 

It's been a warm start to the winter. Also, virtually all major weather forecast models are suggesting the entire eastern half of the U.S. will continue the mild weather for a while, thanks to a strong El Nino weather pattern.

It's hard to see a weather scenario that would be sufficient to draw down inventories enough to inspire gas price recovery back above $2.50. Instead, only a reduction in supply will keep the market from probing the price lows seen last month. 

But it's not all doom-and-gloom.

Just a few short weeks ago, many analysts had been pontificating that end of winter storage levels might come out around 2.7 Tcf or higher. The recent colder weather conditions and corresponding heavier withdrawals experienced in January have operators breathing somewhat easier with projections now coming in south of 2.3 Tcf. 

For a point of comparison, the record level of season-end inventories was set in 2011/12 at 2.474 Tcf. That monumental moment in natural gas history immediately produced price levels similar to those of December 2015. That particular market period would be eventually bailed out by fuel switching in the power generation sector. 

This year is markedly different because gas has already already captured the majority of that market share. Many buyers may wonder if they missed their opportunity, in comparison to the summer of 2012’s strong price recovery.

So unless February winter temperatures come in with an anomalous vengeance, the overall supply and demand equation will continue to be weighted to the supply side. This may set in motion a further decline in gas futures and physical gas prices in the weeks ahead.  

In the meantime stay tuned to your weekly Get the Point reports from PointLogic Energy as we continue to devour the relevant market topics.

Next week, Dr. Rob Applegate takes a look at Industrial Demand.

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