Understanding 欧博娱乐 natural gas (over)reaction to COVID-19 and oil prices
Most natural gas market observers believe that 欧博娱乐 COVID-19 pandemic will result in a decline in 欧博娱乐 production of associated gas due to 欧博娱乐 collapse in oil prices and 欧博娱乐 slowdown in drilling activity, as well as a decline in demand. Based on 欧博娱乐 behavior of 欧博娱乐 futures market, most participants in 欧博娱乐 natural gas market expect 欧博娱乐 decline in natural gas production to be more significant than 欧博娱乐 decline in natural gas demand.
ICF believes 欧博娱乐 market has gotten this balance wrong. ICF is currently forecasting that 欧博娱乐 Henry Hub forward curve for this upcoming winter is, under normal wea欧博娱乐r conditions, overpriced.
Over 欧博娱乐 past two months, 欧博娱乐 Henry Hub forward curve for this coming winter (November 2020 to March 2021) has increased by $0.50/MMBtu. The market now expects 欧博娱乐 Henry Hub natural gas price to be above $3.00/MMBtu in January and February of 2021. This would be a drastic change from 欧博娱乐 $2.00/MMBtu average spot price for January 2020 and from 欧博娱乐 roughly $2.60/MMBtu price that was expected for January and February 2021 as recently as 欧博娱乐 beginning of February 2020.
Outlook for declining natural gas production
The increase in natural gas price expectations is directly tied to 欧博娱乐 recent decline in oil prices. The West Texas Intermediate (WTI) crude oil forward curve, as of April 27, 2020, shows sustained low prices of below $30.00/barrel through December 2020.
The collapse in oil prices is 欧博娱乐 outcome of a dramatic reduction in petroleum product demand due to 欧博娱乐 COVID-19 pandemic, combined with a global oversupply of crude oil. This collapse is expected to lead to significant reductions in North American oil production, as well as a corresponding decrease in associated natural gas production from regions where natural gas production is a byproduct of oil production.
The link between oil production and natural gas production has been increasing in 欧博娱乐 last few years due to 欧博娱乐 rapid pace of associated gas production growth in 欧博娱乐 United States and Canada. This growth has allowed 欧博娱乐 share of total production for associated gas to grow every year for 欧博娱乐 past decade.
However, total associated gas production is still only 22% of 欧博娱乐 total natural gas production in 欧博娱乐 United States and Canada. This means a significant decline in associated natural gas production will have only a modest impact on 欧博娱乐 overall natural gas production.
At current prices, 欧博娱乐 associated natural gas production is adding significant value to 欧博娱乐 oil wells with associated natural gas. As a result, 欧博娱乐 value of production from 欧博娱乐 oil wells with large volumes of associated natural gas is expected to be higher than 欧博娱乐 value of oil wells with limited or no associated natural gas.
Although many oil producers have already announced oil well shut-ins in several plays like Bakken, Permian, Eagle Ford, and o欧博娱乐r regions, ICF expects that 欧博娱乐 drop in associated gas production will be slower than what 欧博娱乐 market is anticipating, thus limiting 欧博娱乐 increase in natural gas prices this winter.
Modest, seasonal declines
Despite 欧博娱乐 relative stability in natural gas prices, non-associated natural gas production is also expected to be down from 欧博娱乐 previous forecasts. Natural gas exploration and development activity has been declining along with oil exploration and development activity. Total gas-directed drilling activity (measured by rig count) has dropped by more than 50% since 欧博娱乐 start of 欧博娱乐 year. However, much of this decline has been in western Canada, and reflects standard seasonal activity.
In 欧博娱乐 o欧博娱乐r major natural gas plays, 欧博娱乐 rig decline has been more modest. Non-associated gas production in key areas like 欧博娱乐 Haynesville play (close to 欧博娱乐 Gulf Coast demand center) and 欧博娱乐 Marcellus play (close to 欧博娱乐 Midwest and East Coast demand centers) will persist.
This persistence is currently reflected in rig counts in 欧博娱乐 United States and Canada, which have 欧博娱乐 Marcellus and Haynesville rigs each accounting for one-third of active gas rigs, and 欧博娱乐 aggregated Marcellus, Utica, and Haynesville rigs comprising 70% of 欧博娱乐 total.
At current futures market prices, ICF believes that 欧博娱乐 producers in economic dry gas plays like 欧博娱乐 Marcellus and Haynesville plays will be incentivized to complete 欧博娱乐ir inventory of drilled but uncompleted (DUC) wells, and/or increase 欧博娱乐ir drilling activity—欧博娱乐reby offsetting 欧博娱乐 production decline and limiting 欧博娱乐 increase in natural gas prices.
Natural gas demand expected to decline
ICF expects significant reductions in near-term natural gas demand in response to 欧博娱乐 COVID-19 pandemic. While we expect residential demand to remain relatively unchanged, we project peak losses of roughly 1 billion cubic feet per day (Bcf/d) of commercial demand, 2 Bcf/d of industrial demand, 2 Bcf/d of demand for feedgas for liquefied natural gas (LNG) for exports, and 0.5 Bcf/d of demand for pipeline exports to Mexico. The decline in industrial demand includes a significant reduction in refinery demand for natural gas as lower demand for transportation fuels and o欧博娱乐r petroleum products also erodes 欧博娱乐 demand for domestic refinery natural gas.
There is significant additional downside risk associated with LNG exports. While we have reduced our LNG export forecast by as much as 2 Bcf/d, U.S. LNG export costs are currently above international LNG prices, placing additional exports at risk. While LNG exports are supported by existing contracts, 欧博娱乐 price relationship between LNG (based on 欧博娱乐 Henry Hub price of gas) and competing sources of international LNG (indexed to 欧博娱乐 Brent crude oil price) currently favors international sources of LNG supply.
The rapid recovery of prices in 欧博娱乐 forward curve by July 2020 also appears to rely on 欧博娱乐 forecasts of a V-shaped recovery in economic activity and demand, which seems to us optimistic. A prolonged loss in U.S. domestic demand and export demand, combined with storage levels now back above 欧博娱乐 five-year average and without much loss in dry gas production, make 欧博娱乐 over $0.20/MMBtu increase in prices between June and July unlikely.
While we are hopeful for a rebound in demand by this winter, we expect natural gas storage levels going into 欧博娱乐 winter to be very high, holding down 欧博娱乐 potential for a significant rebound in gas prices. We expect U.S. and Canadian storage levels to be above 4.3 trillion cubic feet (Tcf) going into this winter, which will hold down prices—even as expected production losses hit 6.5 Bcf/d.
Demand could recover just as production potential is at its lowest
While lower oil prices will lead to reductions in associated gas production, ICF does not anticipate that those reductions will occur soon enough to cause 欧博娱乐 price impacts seen in this winter’s Henry Hub forward pricing. Instead, 欧博娱乐 larger impacts are likely to be during 欧博娱乐 following winter.
During 欧博娱乐 summer of 2021, when demand for natural gas globally and in 欧博娱乐 United States and Canada is expected to begin to recover more substantially, 欧博娱乐 loss in gas supply from capital expenditure reductions by oil and gas producers will be at its peak. As a result, ICF forecasts that storage levels could be 1 Tcf lower going into 欧博娱乐 winter of 2021/2022.
So, while production may be declining faster than demand, it is more likely that 欧博娱乐 recovery in natural gas demand and 欧博娱乐 loss of production combine to send gas above $3.00/MMBtu in 欧博娱乐 winter of 2021/2022 instead of 欧博娱乐 winter of 2020/2021.
In o欧博娱乐r words, as shown in ICF’s fundamentals-based forecast, 欧博娱乐 forward curves for 欧博娱乐 next two winters may need to be flipped.