The Biggest Threat Facing Natural Gas Prices

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About: The United States Natural Gas ETF, LP (UNG), UGAZ, DGAZ
by: Atlas Research
Summary

If current U.S. oil production trends continue, up to 5 Bcf/d in new associated gas could hit the market through 2020.

This would satisfy 100% of my estimated 5 Bcf/d in net gas demand growth, creating a significant bearish headwind for gas prices.

However, U.S. oil drillers risk oversupplying the global oil market based on current production and demand trends.

I detail one future scenario where associated gas production declines despite higher gas prices.

I recently explained how the natural gas bull market was delayed (but not denied) thanks to several export projects missing their summer startup deadlines, leaving the market oversupplied by roughly 2 Bcf/d this summer. But with these delayed export projects (and several others) coming online over the next 12 months, I showed how roughly 5 Bcf/d of net new demand would hit the market by year-end 2020. So that left just one question for estimating the path of gas prices going forward...

What can we expect on the production side of the equation in 2020?

Of course, the elephant in the room of U.S. gas supply comes in the form of associated gas. Produced as an unintended byproduct of oil drilling, associated gas production has boomed alongside record U.S. oil production volumes in recent years. And because associated gas is a price-insensitive source of supply, we must start our gas supply discussion here, before we can address the potential supply from the price-sensitive pure play gas producers.

So in today's article, I will focus exclusively on the potential growth of associated gas through 2020 and beyond. This will then set the stage for future discussions of what we might expect from the pure play gas producers in the Appalachian and Haynesville shale basins (stay tuned for future updates).

Let's get started...

The Permian Floodgates Open

The single biggest source of associated gas in the U.S. comes from the Permian basin - America's largest oil basin - which currently supplies about 9 Bcf/d of gas to the market. That makes it the third largest source of U.S. dry gas production overall, behind Appalachia (~32 Bcf/d) and the Haynesville (~10 Bcf/d).

Now the truth is, the Permian could supply significantly more than 9 Bcf/d absent the artificial constraints of limited gas pipeline capacity. But that constraint will soon lessen with the imminent startup of Kinder Morgan’s Gulf Coast Express pipeline later this month, which will unleash 2 Bcf/d of pent-up Permian gas onto the market. Already in August, early commissioning on the pipeline allowed up to 0.4 Bcf/d in flows, helping Permian production creep past the previous soft ceiling at around 9 Bcf/d as shown below:

How much bottled up Permian production could hit the market given sufficient takeaway capacity? Now no one knows exactly, but we do know that gas infrastructure starting reaching its limits in late 2018 and that Permian gas flaring has reached new record highs in 2019. Meanwhile, before hitting the 9 Bcf/d ceiling back in March of this year, Permian gas production was growing at roughly 2.5 Bcf/d on a year over year basis. So based on all available evidence, it seems likely that the GCX pipeline will have no trouble filling up to its max 2 Bcf/d capacity shortly after coming online later this month.

But that’s just the beginning…

Fast forward 15 months and another 2.1 Bcf/d in Permian gas capacity will open up via the Permian Highway pipeline, slated for “late 2020” based Kinder Morgan's latest timeline. So these two projects alone will unleash up to 4.1 Bcf/d in new Permian gas pipeline capacity through year-end 2020.

Meanwhile, the other two key oil producing regions – the Bakken and the Eagle Ford – are currently growing associated gas production at roughly 0.75 Bcf/d on a year-over-year basis. So if you extrapolate the current production trends (an assumption we'll revisit later), that's roughly 1 Bcf/d from the Bakken and Eagle Ford plus another 4.1 Bcf/d from the Permian, for a total of just over 5 Bcf/d in potential new associated gas supply through 2020. In other words…

Associated gas alone could supply roughly all of the net new gas demand through 2020, if current production trends hold.

Finally, if we look further down the road to 2021, we have another 2 Bcf/d in Permian gas capacity coming online via the Whistler pipeline, currently slated for Q3 2021. And between 2021 and 2023, a long list of additional Permian pipeline projects are waiting in the wings, pending final investment decisions.

So when you consider all of this potential new price-insensitive associated gas that could come online in the coming years, it's easy to make a very bearish argument for natural gas prices. And I'm not here to necessarily refute that argument today - it's a very real risk that anyone in this space should fully acknowledge.

However, what I will show today are the basic assumptions one must make in order for this potential associated gas supply to manifest itself in reality. And this discussion begins by clarifying a common misconception about the supposedly "zero-cost" nature of associated gas.

Price-Insensitive does not Equal Free

Like many popular narratives, the idea of “zero-cost” associated gas oversimplifies a far more nuanced reality. The truth is, associated gas comes with the very real cost of … that’s right ... oil production. It sounds simple, but I can’t count how many commentators routinely discuss the supposedly “endless" source of "zero-cost" associated gas without addressing the single biggest factor in the associated gas supply equation: oil prices.

Simply put, without a sufficient economic incentive to grow oil production, you don’t get growth in associated gas production. We saw this firsthand during the last oil bear market from 2015 - 2016. Consider the case of the Eagle Ford and the Bakken – the two largest, mature shale basins preceding the price collapse (the Permian was only just emerging as the next hot growth basin, although it did suffer a modest drop in growth from a small base). The chart below shows how the combined associated gas production from the Eagle Ford and Bakken flipped from +2 Bcf/d in growth to a contraction of -1.5 Bcf/d when the incentive to grow oil production disappeared in 2015 and 2016: Associated Gas

EIA DPR

So yes, associated gas production may be independent of the gas price, but it depends 100% on oil prices. And in order to fill up all of the shiny new gas pipes coming online in the coming years, U.S. oil production must continue growing at its current pace of 1.5 - 2 million barrels per day (bpd). So that brings us to the next logical question...

Will the global oil market continues absorbing millions of barrels of new U.S. crude supply each year?

Global Oil Markets Facing Oversupply in 2020

First, let me acknowledge that analyzing the global oil supply/demand balance goes well beyond the scope of this article. However, if you just look at the high level math, it's clear that the world faces significant risk of oversupply in 2020. Let's start with demand...

The growth in world oil consumption has been trending lower at an accelerating rate for the last several years, dropping from 1.67 million bpd in 2017 to 1.44 million bpd last year. And based on current consumption trends, the midpoint of forecasts between the EIA, IEA and OPEC indicate a further decline to just 1.2 million bpd of oil consumption growth in 2019. Meanwhile, if you track leading economic indicators, including manufacturing data and key cyclical sectors like autos and semi-conductors, all signs point towards a further drop in growth going forward.

Here's why that's a big problem for U.S. oil producers...

U.S. shale drillers supplied roughly 100% of the growth in global consumption in both 2017 and 2018, and are currently supplying more than 100% of the global growth rate. By the numbers, U.S. oil production has grown by at least 1.5 million bpd on a year-over-year basis for 10 of the last 12 months. That's roughly 125% of the current global rate of consumption growth.

The last time the growth rate in U.S. oil production even approached 100% of global demand was back in 2014. And as most readers will recall, that sparked one of the steepest oil bear markets on record. Of course, the key differences between 2014 and 2019 include 1.2 million bpd in OPEC + Russia production cuts, a sanctioned Iranian oil industry that could be exporting up to 1.5 million bpd and a stunning 1.6 million bpd drop in Venezuelan oil production thanks to the political crisis gripping the country.

On this last point, the chart illustrates the single biggest, and perhaps the least appreciated, factor that prevented global oil prices from crashing over the last couple of years:

In other words, the oil markets have avoided an all-out collapse thanks to more than 3 million bpd in combined production cuts between OPEC + Russia, Iran and Venezuela since 2017. But what are the odds we'll find another few million barrels in spare production capacity that will allow U.S. shale drillers to continue adding 1.5 - 2 million bpd in production growth going forward?

Associated Gas Price-Insensitivity Works in Both Directions

So here's the bottom line...

Natural gas bulls should fully prepare for the worst-case scenario of U.S. oil production continues growing at its current rate, which would supply roughly 5 Bcf/d in new associated gas supply through 2020, and somewhere between 2.5 - 3 Bcf/d thereafter. And just to reiterate, this worst-case scenario assumes that the current rate of U.S. oil production growth continues at 1.5 - 2.0 million bpd going forward.

But in order for this oil production growth scenario to unfold, you need one or all of the following to hold true going forward:

  1. A reversal higher in global economic growth, and thus global oil consumption growth
  2. Ongoing willingness among both OPEC and non-OPEC producers to cede market share to U.S. shale drillers
  3. Continued U.S. political pressure on the Iranian oil industry
  4. Ongoing production outages, or even further declines in Venezuelan oil production

Conversely, what if either of these factors fails to hold up, and U.S. shale drillers oversupply the global oil market in 2020? In that scenario, we could see an environment where the associated gas price-insensitivity works in the opposite direction. Remember, associated gas comes with the cost of oil production... so regardless of the gas price, if oil prices don't cooperate, associated gas growth won't happen.

So one possible future scenario in 2020 or beyond involves an oversupplied oil market and an undersupplied gas market. So we could see a market dynamic where gas prices rise substantially, but it still doesn't bring any associated gas online because oil prices remain depressed. That's the flip side of price-insensitivity.

Of course, I'm not predicting either scenario at this point. I'm simply pointing out that associated gas production presents both a potential headwind, as well as a potential tailwind, to the natural gas supply equation going forward.

Thanks for reading and good investing,

- Atlas

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.