The recent run up in natural gas prices - hitting its highest at Henry Hub since 2008 - is a result of more muted market balancing mechanisms than in the past, say analysts from Wood Mackenzie, a Verisk business (Nasdaq: VRSK).
Eugene Kim, Research Director, North America gas research said: “While initially insulated from the European energy crisis, US natural gas benchmark Henry Hub has more than doubled since its January 2022 contract expiry and has increased by $3 per million British thermal unit (mmbtu) within a month. Despite a near-record mild December and a mild end to the winter in March, underground gas storage withdrawals exceeded the five-year average and reduced storage to its lowest level since 2019. Henry Hub gas prices averaged a mere $2.63/mmbtu in 2019.”
What’s changed in North America gas market fundamentals since then? Kim said: “In the past, higher US natural gas prices would incentivize both a supply and demand response to help correct a market imbalance.”
Higher oil and natural gas prices would historically unleash plentiful low-cost US production. This culminated in 2018 and 2019 where the US cumulatively grew 18 billion cubic feet per day (bcfd) or 19% of current US gas production levels. This powerful growth trend has changed. Kim said: “Producers are not drilling as many new wells as they would have historically at these price levels. They have faced investor pressure to exercise more capital discipline, investing less cash flow back into the fields and instead strengthening balance sheets. Investors are rewarding margin growth over volume growth. Additionally, the ability to ramp up production has been hampered by the institution of environmental, social and governance (ESG), supply chain issues, cost inflation, labour shortages, and increasing difficulty to build new pipelines to bring supply to market.”
“A demand response to higher prices historically cured market imbalances in the very short-term,” Kim said. Fuel switching in the electricity generation sector, means that when gas prices rise, power plants have the economic incentive to switch from using natural gas to coal to generate power, and therefore reduce gas demand. In 2021, limited thermal coal availability and much higher coal prices meant natural gas plants still garnered market share over coal plants. The price elasticity of fuel switching seemingly disappeared as Henry Hub gas prices increased above $3.50/mmbtu. Kim added: “As prices increased to $4/mmbtu, $5/mmbtu, and even $8/mmbtu, coal plants did not start up to reduce gas demand.”
As the US continues to add liquefaction capacity to supply the global market, LNG exports have doubled, compared to 2019. And with the Russia/Ukraine war, the call on US LNG is set to increase further over the next years.
With supply and demand’s response to higher prices more muted than in the past, where do we go from here? Wood Mackenzie asserts that if upstream investments in the US continue to disappoint, the market will be searching for a new ceiling price to help balance the market. Kim added: “The last resort would be for the market to push US LNG exports back into the domestic markets if a clear and present danger of running out of gas this upcoming winter comes to fruition.”
And what if those International prices stay high? “It’ll be a race to the top – ultimately the cure for high prices is high prices.” Wood Mackenzie concluded that in the longer-term, the forces of supply and demand will bring the market back into balance: “A high enough price will promote higher supply while destroying demand. But first, a hot summer and cold winter would spell disaster in the near-term,” Kim added.