Natural Gas: Oversupplied But Prices Could Still Double In 2019

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About: The United States Natural Gas ETF, LP (UNG), Includes: AR, CNX, COG, EQT, GPOR, RRC, SWN
by: Atlas Research
Summary

Despite today's low gas storage, the market is oversupplied.

The market consensus has priced in continued oversupply going forward, but early evidence suggests a meaningful production slowdown in 2019.

As slow supply growth undershoots consensus expectations, I see high odds of a tighter market and higher prices in the second half of 2019.

In October 2018, I explained how natural gas prices could double in 2019.

Today, the natural gas (UNG) market is oversupplied and prices remain stubbornly around $3 - about the same price as 6 months ago. However, I still believe prices could soar as we move through 2019. The reason? Production will fall short of market expectations.

In this article, I'll explain why natural gas production growth will slow dramatically in 2019. This slowing production will meet the new demand growth in the second half of the year, tightening the market and sending prices much higher. But first, let's see where the market stands today.

Despite Low Storage, Natural Gas is Oversupplied

Natural gas storage currently sits 30% below the five-year average - the largest deficit in over four years:

On the surface, this storage deficit might seem to indicate an undersupplied market. But today's deficit is purely a function of a low starting point. You see, we entered last winter with the lowest natural gas inventory in 13 years. This low starting point combined with an early-November cold blast to ignite an epic short squeeze, fueled by offsides traders - like the now-infamous OptionsSellers.com.

(And don't let the weepy-eyed apology video fool you. Anyone with even a cursory knowledge of derivatives knows the immense risk of selling naked commodities options on leverage. OptionsSellers.com did not suffer from a "rogue wave." They could have easily hedged their risk by selling call spreads instead of naked calls. But that would have given up their potential upside. So they sold naked call options for maximum gains and thus exposed their clients to catastrophic risk. That's just greed, plain and simple. And now I'll jump off the soapbox).

After November's brief short-covering rally, one of the warmest Decembers in years was followed by an unseasonably warm January, sending gas demand and prices tumbling back down. And despite gas inventories plumbing 4-year lows, prices remain stubbornly below $3 on both a spot basis and through much of the 2019 - 2020 forward curve. That means traders are convinced that an oversupplied gas market will erase today's gas deficit during the upcoming storage refill season (April 1st through October 31st).

And while I love a good contrarian bet, all signs indeed point to an oversupplied market… at least for now. We can see evidence of this oversupply by comparing this winter versus last. Let me explain…

First, let's compare the coldness of this past winter (2018/2019) versus the previous year (2017/2018) using "heating degree day" (HDD) data. Heating degree days simply measure how cold a given region is versus a baseline temperature. In the U.S., the standard baseline is 65 °F. So a 35°F day would generate 30 HDDs, and two 35°F days would generate 60 HDDs, and so on.

During the winter season, the relationship between HDDs and natural gas demand is roughly linear. So 10% more HDDs should translate into about 10% more heating demand for natural gas, all else equal. In the chart below, you can see that last winter generated about 5% more HDDs than the previous year:

By the numbers, we accumulated 4,024 HDDs during the 2018/2019 winter. That's 4.76% more than the 3,841 HDDs accumulated in the 2017/2018 winter, according to HDD data from the American Gas Association. So all else equal, we should have drawn down gas inventories by roughly 5% more this winter versus the previous year. But all else was not equal. As you can see in the chart below, we drew 17% less gas from storage this winter versus the previous year:

As a very rough approximation, this winter's 5% greater heating demand and 17% lower storage draws implies we were oversupplied by about 475 billion cubic feet during this past winter, or roughly 3 Bcf/d. (Author's Note: Don't take this as gospel; it's a very rough approximation for the sake of argument.) Now, 3 Bcf/d might not sound like much on the surface, but consider this….

The U.S. ended the winter gas drawdown season with 1,107 Bcf of gas in storage on March 29th. That's 505 Bcf below the 5-year average end-of-winter storage level of 1,635 Bcf. And with the storage refill season spanning just over 200 days, you can see how a persistent 3 Bcf/d surplus could generate over 600 Bcf of excess supply. That would transform today's 500 Bcf deficit into a mild surplus by the start of next winter. Now that's just a hypothetical example, but it happens to fall within the ballpark range of the official projection from the Energy Information Agency ("EIA").

In the EIA's latest short-term energy outlook, the agency projects that we will almost completely erase today's storage deficit and end the refill season with gas storage just 1% below the 5-year average. Said differently, the EIA projects that in the 213 days from April through October, the market will supply an excess of roughly 500 Bcf - or 2.3 Bcf/d. And with nearly every gas futures contract in 2019 trading under $3, the market consensus has priced in a similar forward outlook.

Now here's the critical assumption supporting this EIA projection: another year of massive U.S. production growth. Specifically, the EIA forecasts that U.S. producers will add 7.6 Bcf/d of new gas supply in 2019. That's about 25% less than the record 10 Bcf/d added last year, but still very aggressive growth. And that brings us to the crux of the issue for natural gas prices in 2019 …

Do you believe the EIA production forecast?

Now, I'm no permabull on natural gas prices. If I believed this production forecast, you'd see me release an article titled: "Why Natural Gas Prices Won't Go Anywhere in 2019." But the objective evidence indicates that the EIA's production forecast is simply too aggressive. Here's why…

Lower Capex and Lower DUC Inventories = Lower Supply Growth

I recently explained how investor demands for less growth and more cash generation were forcing producer restraint in the shale patch. That trend is showing up in capex cuts across every major shale gas producer I track. The list includes EQT (EQT), Range Resources (RRC), CNX Resources (CNX), Antero Resources (AR), Southwestern Energy (SWN), Cabot Oil and Gas (COG) and Gulfport Energy (GPOR).

These top gas drillers get the bulk of their production from Appalachia - America's fastest growing and most productive gas basin. Pennsylvania's Marcellus formation forms the heart of the Appalachian basin, so tracking the state's drilling permits provides a useful leading indicator for Appalachian production. Below, you can see how Pennsylvania drilling permits started the year with a mild 8% drop, but then accelerated to roughly 50% declines in February and March:

If this trend persists, there's every reason to believe that Appalachian production growth could slow dramatically in the region. And this drop in drilling permits becomes even more bullish when you consider DUC (drilled but uncompleted) well dynamics.

You see, drilling the well is by far the most expensive step in bringing new production online. In recent years, Appalachian drillers have tapped into their DUC inventories to get more production bang for their capex buck. In the chart below, you can see that Appalachian shale companies have drawn down their DUC inventories by 60% since 2014:

Last year alone, Appalachian drillers burned through nearly 200 DUCs to deliver 2018's record production spurt. And with only about 500 DUCs left in Appalachian inventory, can they repeat this feat in 2019? Unlikely.

You see, DUC inventories will never fall to zero. That's because of the inherent time lag between drilling and completing a well. Think of it as the natural level of inventory a retailer will carry between receiving merchandise and making a sale. We don't know what the natural DUC count should be for Appalachian drillers, but recent trends suggest that we may be approaching the low end of that number. Consider the following…

From January through October of last year, Appalachian drillers drew down 162 DUCs or an average of 18 per month. But in the three months from December through February (the most recent EIA data), DUC drawdowns slowed to just 3.5 per month on average. That's a decline of more than 80%. And the timing of this deceleration is curious...

Remember, over the last few months, investors have clamored for shale companies to start generating free cash flow. So there's never been a greater incentive for shale drillers to tap DUC inventories and boost cash flow with minimal capex. And yet, the rate of DUC drawdowns has slowed to a crawl. Occam's razor says Appalachian shale drillers have stopped tapping their DUCs for one simple reason - they've run out. This is just my hunch, but time will tell.

The bottom line: less capex plus lower DUC inventories equals a big drop in Appalachian wells coming online in 2019. Less wells mean a lower rate of production. And the early production data so far confirms this view.

Has U.S. Gas Production Stalled?

This January, U.S. gas production fell to 88.6 Bcf/d, down from 88.9 Bcf/d in December. Admittedly, that's a small decline. But remember, we don't need an outright decline to balance the market. Anything less than blistering growth is a big positive for balancing the market, and a small decline is even better. That's because of the huge new demand coming online from ramping U.S LNG export capacity, plus pipeline exports to Mexico and gas-fired power demand.

Unfortunately, the latest available EIA data we have only goes through January. But energy research firm Bentek provides a daily estimate of lower 48 U.S. gas production. And in the chart below, you can see that Bentek estimates we haven't even posted a single new high in U.S. gas production in the first 100 days of 2019:

Of course, these estimates could get revised higher in the coming weeks. But for now, it's simply one more piece of the production puzzle indicating a meaningful slowdown in the rate of growth this year versus 2018. As we move into the second half of the year, we start lapping last year's massive production increase. That means shale drillers will need to step on the gas to hit the EIA's 7.6 Bcf/d production target in the second half of the year. But based on the depleted DUC inventories, lowered capex, and collapse in Pennsylvania drilling permits - I see low odds of that scenario unfolding. That's why I remain bullish on natural gas as we move into the second half of 2019.

Stay tuned for future updates.

Disclosure: I am/we are long RRC. 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.