Bullish outlook for US gas - LNG exporters face margin squeeze in glutted market

As oil prices touch year highs on OPEC's production cuts, US gas prices are in the midst of a rally of their own. Last June we predicted a squeeze on US gas prices this winter with ramifications for global gas markets. With winter upon us, is gas moving too?

US weather extremes have played havoc with Henry Hub gas prices over the last month. Lulled by a warm spell, spot gas prices slipped from US$3/mcf at the start of November to just over US$2/mcf. A mid-November temperature plunge in Texas, from 27 deg C to just above zero inside 24 hours, kick started winter sending prices back up to US$3/mcf.

Our North America gas team, led by Jen Snyder, is bullish on Henry Hub prices.

We believe the forward curve is still not pricing in a tighter market. Nymex has the 2017 contract at US$3.30/mcf, whereas we forecast US$3.70/mcf.

The sharp response of the physical market to the arrival of cold weather suggests fundamentals are tight and prices could go higher, whether it's a cold winter or not. There are four main reasons why.

First, production growth from the US L48 has stalled, with a decline in drilling and lack of market access in the North East basins. Increased drilling in tight oil since mid-year has added some supply, but insufficient to cover declines in associated gas. Winter US L48 gas production is expected to be 1.4 bcfd lower compared with last year.

Second, US LNG exports are at full tilt. Volumes from Sabine Pass, the only plant on stream, are being placed into premium, emerging growth markets - but not Europe as yet.

Third, US import and export pipeline dynamics are changing. The stalling of planned LNG export projects from Western Canada has prompted operators like Shell and Petronas to rein in drilling programmes aimed at proving up reserves. Canadian exports to the US should decline by 0.4 bcfd. Meantime US exports to Mexico should rise by 0.4 bcfd through the winter with new pipeline capacity opened up.

Fourth, underlying US gas demand is stronger than expected. Industrial demand in September hit new highs for the month. Renewables are competing with gas for market share in power, but there has been heavier demand for gas from co-generation and refineries, whilst the early start up of fertiliser plants should sustain growth through this winter and into 2018.

Even if this winter is 'temperature normal', we expect inventories to drop to three year lows in March 2017.

A strong re-injection season next summer amid the firm underlying supply and demand dynamics outlined should underpin prices through 2017.

Great for US gas producers, who on our 2017 forecast could realise gas prices 50% above the 2016F average spot of US$2.45/mcf. Producers have already hedged 37% of 2017 production, a little higher than the last two abnormally low years. Two thirds of output is unhedged, and leveraged to any upside.

But perhaps not so clever for US LNG players, the new marginal supplier to the European gas market. US LNG exports are due to ramp up to 11 mt in 2017 from 4 mt in 2016, just at a time when new LNG supply from Australia and Malaysia is also hitting the market. Liquid NW European hubs may have to absorb more than twice as much LNG volume in 2017 as 2016. With little room in Asia, US LNG will be competing on price in Europe with cheaper Russian pipeline gas, both vying to displace coal from the power market.

Our European gas team, led by Massimo Di-Odoardo, expects European gas prices (NBP) to sag under the weight of new volumes. The differential of NBP over Henry Hub averages just US$1.50/mcf on our forecasts through 2017, enough to cover the variable costs of sourcing gas, shipping and regasification.

But the differential won't necessarily cover costs all the time. Our 2H 2017 price forecasts suggest 1 mt or 15-20% of US LNG volumes might be cash negative.

There may be more volumes in loss if Russia shoots for market share and pushes more gas into the market. Much as US tight oil producers' margins have swung with OPEC's Saudi-led 'taps on, taps off' shifts in strategy, so too perhaps for US LNG exporters and Russia.

With global oversupply, those emerging LNG markets become increasingly critical for US exporters.