While the Henry Hub price remains the most broadly quoted and watched benchmark for U.S. natural gas, its relevance to investors focused on E&P stocks has substantially diminished recently.
Traditionally, the Henry Hub has been the natural gas price proxy for the Producing Region and an adequate benchmark for natural gas realizations seen by the majority, in terms of the number and combined market capitalization, of natural gas producers. Local basis differentials have always existed but, with few exceptions such as the takeaway capacity-constrained Rockies region several years ago, have represented a relatively small percentage of the realized price.
The market's structure is rapidly evolving, however. With the Marcellus and Utica already providing over 20% of the U.S. aggregate natural gas supply and quickly becoming net exporters of natural gas, the Northeast Region pricing points are increasingly important benchmarks for many E&P companies and are critical to the understanding of the sector's economics in general.
The Northeast Region pricing points are also increasingly relevant to stock investors as the combined market capitalization of Marcellus- and Utica-focused operators represents a disproportionately large percentage of the total Natural Gas sector market capitalization.
Given the availability of several major interstate pipelines connecting the Gulf Coast and the Northeast Region, one would expect a more or less predictable relationship to emerge between the Henry Hub and Marcellus pricing points once the balance of inter-regional flows is established. During the transition period, however, when existing pipeline flow configurations no longer reflect the market's demand, such a relationship simply does not exist. Given the magnitude of the potential Marcellus and Utica production growth, such a transition period may last for quite some time.
The following graph shows how deep the disconnect has been this year between the two regions' pricing.
While many investors may think of the 2012 price environment as the absolute worst the industry has seen in a very long time, the current pricing in the Marcellus Region is in fact just as poor. The current quarter basis differentials in the Marcellus area may prove to be the worst of the four quarters in 2014. The widening of the basis is further exacerbated by the overall decline in natural gas pricing nationwide driven by the healthy pace of storage injections. In fact, the current pricing at certain Marcellus hubs is so low that shutting in production may make economic sense for producers.
As seen from the following graph, the historical Gulf Coast/Northeast Region pricing relationship broke down at the end of 2011, the same time when the glut of new production from the Haynesville and Marcellus sent natural gas prices into a tailspin. The graph represents the historical basis and basis futures for TCO Appalachia as of August 2013, a year ago. It shows an approximately $0.50/MMBtu swing in basis over a two-three year period. Actual basis change may prove much wider, at least in the near term, relative to what the market expected a year ago.
How long will the current Northeast basis anomaly last? Some market participants take an optimistic view that gas take-away constraints in the Marcellus/Utica will be mostly alleviated in less than two years. The slide below from Eclipse Resources' (NYSE:ECR) presentation shows a forecast that implies a significant surplus in takeaway capacity relative to production already in 2016.
(Source: Eclipse Resources, August 2014)
Eclipse's forecast may prove to be a bit optimistic, however, given that some of the projects have already experienced delays relative to their original schedules and permitting of new projects often takes longer than planned. It is also important to take into account that for many of the new projects to go ahead, producers must sign binding multi-year demand commitments that lock in high transportation costs for decades to come. For such decisions to be made, producers must see a credible threat of persistently wide basis. It is difficult, therefore, to rule out a scenario that basis spikes may continue well beyond 2015, at least at certain pricing points.
Given the current structure of the market for natural gas, there is a need for an alternative benchmark to Henry Hub that would, at minimum, more adequately represent pricing in the Northeast region and, at maximum, rival Henry Hub. Unfortunately, such a benchmark may not emerge easily. Henry Hub has the benefit of much greater interconnectivity to multiple large interstate pipeline systems and storage capacity than any of the major Northeastern trading hubs (shown below). Moreover, Northeastern pricing points will remain at risk of basis singularities until local bottlenecks that limit connectivity between various pipeline systems in the Northeast are addressed. This may take time and significant capital.
In the longer perspective, Henry Hub will likely preserve its importance due to its position close to the export LNG outlets on the Gulf Coast that may account for as much as 10 Bcf/d of gas exports already by 2020. However, the emergence with time of a Northeast natural gas pricing benchmark that would rival Henry Hub in relevance and liquidity is logical.
Which Stocks Are The Most Exposed To The Marcellus/Utica Basis Differentials?
- Antero Resources (NYSE:AR)
- Cabot Oil & Gas (NYSE:COG)
- Eclipse Resources
- EQT Corporation (NYSE:EQT)
- Range Resources (NYSE:RRC)
- Rex Energy (NYSE:REX)
- Rice Energy (NYSE:RICE)
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