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Larger Than Expected Natural Gas Inventories Spells Trouble for Producers

In a surprising turn of events, rising supplies of oil and tepid global demand have caused prices to crash to their lowest levels in years.

And the same phenomenon may be playing out for natural gas, at least in the United States. An increase in supply and soft summer demand are combining to see rapid build ups in storage inventory, according to new data from the Energy Information Administration.

But let’s back up a minute.

The unusually cold winter of 2014 saw a record-breaking drawdown in natural gas inventories as power plants ramped up to supply enough heating, particularly on the east coast. That led to natural gas storage in the U.S. to drop to an eleven-year low, and prices temporarily spiked in response to high demand.

As the east coast thawed out, demand fell back to their usual levels, but many analysts predicted that the effects of the brutally cold winter would reverberate in the months and even years to come.

The problem comes down to whether or not production would exceed consumption to such a degree that inventories would rebuild. Normally, inventories are built between April and November, as demand is low enough to allow excess natural gas volume to be syphoned into storage. Then, with the onset of winter, inventories are drawn upon, depleting until the spring.

But many feared that the unusually cold winter of 2014 would mean that natural gas inventories were so depleted that the U.S. would struggle to refill storage in time for the next winter.

The ongoing switch from coal-fired power plants to natural gas adds to the challenge by making the country more dependent on a single fuel. And potentially making matters worse was the possibility of a hot summer, in which once again inventories would be drawn down to power air conditioners around the country.

As a result, many analysts predicted a period of sustained high natural gas prices. Investment analysts, including this column, predicted sunny days for shale gas producers as high prices would both lift profits but also lead to an uptick in drilling activity. As a knock-on effect, there would be a resurgence in demand for coal, as it could successfully compete with higher natural gas producers.

But, that scenario has not come to pass, for several reasons. First, the hot summer never happened. The U.S. east coast experienced one of its mildest summers in years, depressing demand for electricity. That helped to keep a lid on prices.

Henry Hub Natural Gas Spot Prices

Second, natural gas production continues its impressive climb upwards. As of June 2014, dry natural gas production hit 70.2 billion cubic feet per day (bcf/d), up 6 percent from a year earlier. Taken together, the U.S. has significantly more natural gas on hand than expected.

In other words, natural gas inventories are building back incredibly quickly. According to the EIA, natural gas storage dropped below 1 trillion cubic feet (tcf), which was about half of the average over the past five years. But since April, much of that deficit has been erased.

Natural gas storage injections – deposits of volume into storage – are also outpacing the five-year average. To understand this dynamic, see the EIA chart below. The gap between the five-year average and the 2014 levels of storage – a gap of around 1 tcf – has narrowed to just 463 billion cubic feet (bcf) as of September 5. The EIA predicts further injections in the coming weeks, shrinking the deficit to just 355 bcf by the end of October.

Weekyl Natural Gas Inventories Over 5 years

However, heading into winter, the U.S. will still be equipped with natural gas storage well below normal levels. That would portend the potential for a price-spike scenario again, in which cold weather shrinks inventories to dangerously low levels. But, the EIA says that as natural gas production continues to increase, the seasonal effect – the ebb and flow of prices due to temporary fluctuations in demand – will continue to wane. In other words, changes in seasons are becoming less important because of strong production in the east, near to large consumer markets.

Average price spread for natural gas next 5 years

Higher than expected production and lower than expected demand mean that the market is well-supplied at this point. Futures prices for natural gas continue to decline. For October delivery, natural gas prices declined by 3.3% after an EIA storage report was released on September 11 showing impressive inventory gains.

Henry Hub prices are hovering below $3.90 per million Btu (MMBtu), with futures prices for October below $3.8/MMBtu.

This is a remarkable turnaround from earlier this year. So what are we to make of this?

First, a well-supplied market spells trouble for a variety of energy producers. Chesapeake Energy (NYSE: CHK), the second-largest natural gas producer in the United States has disappointed investors this year. Chesapeake, which has bet the farm on natural gas, is vulnerable to Henry Hub price swings. The share price rose 15% from January to June of this year. But since peaking in June, Chesapeake’s share price has shaved off nearly 20% of its value as of mid-September.

Devon Energy (NYSE: DVN) is in a similar situation. Devon produces heavy oil in Canada, tight oil in the Permian Basin, and shale gas from the Barnett Shale (among other places). It has a heavier focus on oil and liquids-rich areas than Chesapeake. Since these products are much more lucrative, Devon is a bit more insulated than Chesapeake, but still vulnerable to the down swing in prices. Its share price rocketed by 28 percent since the beginning of the year through the end of June. It rode the wave of higher natural gas demand. But as prices began to decline during the summer, so did Devon’s share price.

But it is not just natural gas companies. Coal companies too are suffering from the surprisingly strong position the U.S. finds itself in regarding natural gas supplies. Coal companies, already clobbered by a glut in international supplies and falling demand in the U.S., had been betting on a comeback in 2014 – precisely because of strong winter demand earlier this year. But with inventories nearly rebuilt to the five-year running average, the coal industry will resume its downward descent into the abyss.

Arch Coal (NYSE: ACI) got its hopes up this past winter with stronger demand. Its stock price jumped by 16% between January and April. But from there, it has plummeted. Warm weather and deteriorating conditions for the coal industry more broadly caused Arch’s share price to fall by around 40% since April.

The story is similar for other coal producers. Consol Energy (NYSE: CNX) witnessed a nearly 25% increase in its share price between January and June, but since then it has fallen back by 17%.

We are in the midst of a down market for energy producers, and investors need to be cautious. Over the long-term, natural gas producers should be strong bets as demand will only rise as more coal plants are shuttered. But for now, it is time to wait out this period of low-prices. Better for investors to put their money in companies that use natural gas as a feedstock.

Take Dow Chemical (NYSE: DOW). The company manufactures all sorts of chemical products that use natural gas products – ethane, propane, condensate – as feedstocks. Lower than expected natural gas prices will boost Dow’s bottom line as it cuts back on costs. Dow has benefited enormously from the shale gas revolution, and it will continue to prosper as long as natural gas prices remain low.

Another interesting bet would be Cheniere Energy (NYSE: LNG). Cheniere is building a liquefaction facility on the Gulf of Mexico to send liquefied natural gas (LNG) overseas. It has contracts in hand for 20 years’ worth of exports, giving it confidence it can grow over the long-term. The pivotal variable is natural gas prices, which is an input for the company. Lower prices means Cheniere will bring in more money for its LNG sales.

Natural gas prices are historically volatile and fickle. Prices can rise just as quickly as they fall, and it is hard to predict what they will do in the coming months, let alone several years from now. Nevertheless, natural gas prices are much softer than many anticipated after this year’s cold winter. With the cold season still a few months off, the U.S. is rapidly restoring its inventories and production continues to climb. This suggests prices won’t necessarily spike automatically as cold sets in. As a result, the current period of low prices will likely cut into profits of energy producers, so investors should take note.

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