Natural Gas Usage In The Electric Power Sector: What Do The Latest Trends Say About Future Prices?

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Includes: BOIL, DGAZ, FCG, GASX, KOLD, UGAZ, UNG, UNL
by: Bluegold Research
Summary

Electric Power sector is the primary consumer of natural gas.

Analyzing four key indicators to monitor.

The natural gas storage level might not even reach 3,000 bcf by the end of October 2018.

Either production needs to rise even more, or prices must stop falling and start rising again.

More than half of the withdrawal season is already behind us. The March contract will expire in two weeks and, increasingly, natural gas trading will be getting less weather-dependent and more price-dependent. Therefore, we thought it was the right time that we relaunch our regular monthly series focusing on natural gas usage in electric power and update you on the latest trends.

Why should natural gas traders care about the latest trends in the electric power sector?

The simple answer is because the electric power sector is the primary consumer of natural gas. Its share in the annual demand structure is more than 30%, while its share in the injection season demand is close to 50% (see the charts below).

Source: Energy Information Administration, Bluegold Research estimates and calculations

Source: Energy Information Administration, Bluegold Research estimates and calculations

Unlike heating-driven demand from residential and commercial users, electricity-driven demand from the electric power sector is much more sensitive to price changes. It is precisely this high price elasticity of demand that makes trading during the injection season more price-dependent and less weather-dependent. High price-elasticity of natural gas demand during the injection season is also the primary reason for another, subtler phenomenon. History shows that the lowest prices during the injection season have been higher that the lowest prices during the withdrawal season (see the table below).

Source: CME Group, Bluegold Research estimates and calculations

As you can see, the average of injection season "price minimums" is higher than the average of withdrawal season "price minimums." Indeed, we have seen cases in the past, when warm winters pushed natural gas prices as low as $1.70 per MMBtu, yet we have never seen cases (at least in the recent past) when cool summers pushed prices below $2.20 per MMBtu (for summer contracts). That's because cheap natural gas during the summer is much more supportive of consumption than cheap natural gas during the winter. By the way, it's also the reason why the highest prices during the injection season have always been lower than the highest prices during the withdrawal season.

What indicators should traders monitor?

Here's a list of four key indicators that we think should be monitored:

  1. The spread between natural gas and coal (NG/coal spread) - measures the competitiveness of natural gas usage in the Electric Power sector vis-à-vis its closest substitute, coal; specifically, Central Appalachian coal (bituminous) and Powder River Basin coal (sub-bituminous).
  2. Fuel Cost Index (FCI) - like NG/Coal spread, FCI measures the cost of natural gas usage for electricity generation relative to coal, but because it is an index based on a recent price, it can potentially identify important "highs" and "lows," which respectively act as support and resistance.
  3. Generation capacity - the amount of natural gas-fired power plants measured in megawatts.
  4. Coal-to-gas switching - is a displacement of coal-fired generation by natural gas-fired generation due to short-term fuel price competition. Coal-to-gas switching has a positive impact on total natural gas demand. It occurs because of lower natural gas prices relative to coal. The lower the NG/coal spread is, the stronger is the impact of coal-to-gas switching and the higher is the consumption of natural gas in the electric power sector.

Let's now look at each of these indicators in more detail.

NG/Coal Spread

The price of U.S. coal and natural gas have been moving in the opposite directions since 2017 (see the chart below), which is somewhat surprising because these commodities are supposed to substitute one another in the electric power sector. At least until spring 2016, their performance was more aligned.

Source: CME Group, Energy Information Administration, Bluegold Research estimates and calculations

As the prices diverged, the spread between natural gas and coal has narrowed and even became negative for some coal types -- notably, Central Appalachian brand (see the chart below). Indeed, the spread between natural gas and coal has reached the levels unseen since April 2012.

Source: CME Group, Energy Information Administration, Bluegold Research estimates and calculations

Fuel Cost Index

Predictably, the narrowing of the NG/coal spread has pushed fuel cost index (FCI) lower (see the chart below). Notice that FCI often hits "seasonal lows" just before the winter (yellow circles on the chart) and right after the winter (red circles on the chart). Currently, FCI is lower than in was back in February 2017, but slightly higher compared to the February 2016 low. In this respect, we would like to remind you that a very low FCI during 2016 injection season triggered massive power burn, which even lead to a draw in storage (for the week ending July 29, 2016) -- an extremely rare occurrence for injection seasons.

Source: CME Group, Energy Information Administration, Bluegold Research estimates and calculations

Generation Capacity

The total stock of natural gas-fired power plants continues to increase. As of March, 2017 it stood at 447.5 GW, which at that time accounted for 41.4% of total generating capacity in the U.S. By March of this year, natural gas share in the total fuel mix is expected to rise by almost a full percentage point (to 42.2%) and equal just around 452.2 GW (see the chart below).

Source: CME Group, Energy Information Administration, Bluegold Research estimates and calculations

Notice also that the share of "other renewables" (wind and solar) will overtake hydro and nuclear power. Previously, in an attempt to estimate the levels of potential natural gas consumption in the electric power sector, analysts would look at the schedule of nuclear outages to try to figure out how many nuclear megawatts will be replaced by natural gas. They would also study the level of snowpack to estimate hydro inflows and eliminate it from total calculations.

Now, however, analysts must also study wind speeds and the levels of solar radiation since the influence of "other renewables" can no longer be ignored. In this regard, please note that out of 12 calendar months, February has historically been one of the weakest months for renewable power (see full ranking in the chart below).

Source: Energy Information Administration, Bluegold Research estimates and calculations

Coal-to-Gas Switching

Our analysis shows that the level of coal-to-gas switching is already running at no less than 5 bcf/day and possibly even more. At current natural gas and coal forward prices, this level could potentially rise to 7 bcf/day this summer. Power burn is already rising sharply in both MISO and PJM (see the chart below).

Source: PJM, MISO Energy, Energy Information Administration, Bluegold Research estimates and calculations

Long-Term Storage Forecast

Our preliminary calculations indicate that if the current share of natural gas usage in the total fuel mix stays unchanged and continues to rise into summer, natural gas storage level might not even reach 3,000 bcf by the end of October 2018. Of course, this is a very long-term forecast and is therefore quite unreliable. But it still shows that the current forward curve is too low for the upcoming injection season, and that either production needs to rise even more or prices must stop falling and start rising again to ensure that the underground storage gets filled with additional 1,600-1,800 bcf of natural gas by the end of October 2018.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.