ANatural Gas Markets to Capitalize on Volatility in 2017

ENERGY AND COMMODITIES

NATURAL GAS MARKETS TO CAPITALIZE ON VOLATILITY IN 2017

1Natural Gas Markets to Capitalize on Volatility in 2017

2016 was an “interesting” year for the U.S. natural gas markets. Though prices ended on a high note, hitting $3.70/mmbtu at year’s end, much happened between Jan 1 and December 31 – gas storage reached historic highs, prices hit record lows, producers continued stacking rigs and production declined almost 4 BCFD. Now, with the first month of 2017 in the rearview mirror, gas prices have fallen back to the low $3 range, the storage outlook is unclear, producers are slowing starting to drill again, and the outlook for prices for the rest of the year is very uncertain, perhaps more so than any time in recent memory.

While the U.S. shale gas revolution has brought new resource wealth and ushered in new opportunities for producers, pipelines, traders and retailers, the massive shifts from conventional fields to shale have fundamentally changed this market. With these still developing shale fields requiring massive new investments in plants and pipelines, and with the ability for producers to bring on huge quantities of new supply in relative short order, regional imbalances are occurring and prices differences among those regions have been magnified. More generally, the new and abundant supply of gas has driven down prices and encouraged increased consumption for power generation and export to global markets.

These market trends and shifts continue to be ongoing, and the uncertain interplay of these factors will determine the shape of prices and the financial health of individual market players for years to come.

Shifting from coal to gas

Cheap gas, combined with intensifying environmental regulation of coal-fired generation, has increased the use of natural gas for both peak and baseload power generation. With this increased reliance on natural gas, the Federal Energy Regulatory Commission (FERC) has been actively working to improve the operational coordination between the gas and power markets, such as with Rule 809, which was issued in 2015.

With this rule, the FERC moved the timely nomination cycle deadline for scheduling from 11:30 a.m. CT to 1:00 p.m. and added a third intraday nomination cycle during the gas day – all so that generators could better manage gas supplies to meet actual burns. This single rule significantly impacted gas suppliers, traders and pipelines operators by requiring new systems and new processes.

Should gas continue to displace coal for power generation, it can be expected that the FERC will mandate additional changes. These changes could include shifting the start time of the gas day to 4:00 a.m. CT to better match the power day, a move that has been requested by the power markets and one that would have significant impacts on the gas industry.

In its most recent forecast, the U.S. Energy Information Agency (EIA) said it believes that natural gas will continue to replace coal, noting that “the U.S. is expected to increase gas-fired generation by 11.2 gigawatts (GW) in 2017 and 25.4 GW in 2018 … increasing U.S. gas-fired power capacity by about 8 percent over 2016 levels.” However, these additions, which could add a BCF or more of generation gas burn on top of the current full year average of about 25 BCFD, are not a certainty. If gas prices increase substantially or if the new Trump administration follows through on its promise to ease the environmental rules that have led to planned early retirements of coal-fired plants, these new gas-fired additions could be delayed or canceled.

Gas exports are growing

The wealth of shale gas reserves being developed in the U.S. has also attracted a lot of international interest, particularly from neighboring Mexico. Gas buyers in that country are moving U.S. gas south in increasing volumes as Mexico’s domestic production declines and liberalization of the gas markets advances.

According to the EIA, exports reached 4.2 BCFD in August 2016 (the last month of available data), and those exports will increase with the completion of additional border crossing capacity in South Texas. These new capacity additions include the just completed San Elizario Border Crossing Project, which adds over 1 BCFD of gas flow from San Elizario, Texas, into San Isidro, Chihuahua, Mexico. With further expansions and additions coming online throughout 2017, the current capacity of 7.3 BCFD will increase to nearly 11 BCFD by the end of the year.

NATURAL GAS MARKETS TO CAPITALIZE ON VOLATILITY IN 2017

2 Natural Gas Markets to Capitalize on Volatility in 2017

Where is all this heading?

While seasonality and weather are the primary determinants of short-term natural gas prices, the increasing complex array of factors at play in today’s market could exacerbate volatility. With large increases in demand for U.S. natural gas focused on a few specific markets or segments (power generation, Mexican exports and LNG), upsets in these markets, significant regulatory or political changes, or even market rumor related to these factors will undoubtedly add downside pressure to prices. And should demand unexpectedly decline or producers return en masse to drilling, the market will again become largely oversupplied, and prices could rapidly fall back to the low levels of early 2016.

Dealing with uncertainty

While many of the changes in the market are obvious, such as increasing exports, the magnitude and the impact on prices of those individual changes is uncertain, and the effects brought about by the interplay among them is even more unclear.

Companies operating in this market need to continue to be acutely aware of their surroundings and leverage technologies that can improve their vision of market conditions and commercial exposures as well as tools to help limit risks and improve financial performance.

Unfortunately, many companies, facing declining margins due to low prices, have cut back on technology spending, and their current systems are not up to the task of effectively managing the risks of a volatile market. In particular, gas retailers, who operate amid fierce competition and with thin margins, can be especially vulnerable to the price shocks of high volatility, as a year’s profit can be lost almost overnight. For those retail gas providers that don’t have the appropriate systems in place to manage volatility in their supply portfolio, 2017 could be a very difficult year.

Obviously, nobody can accurately predict what natural gas prices will do a year out – or even a month out. Still, it does appear that this market is going to be substantially more difficult to forecast than in previous years. The supply and demand balance is clearly transitioning, with both sides becoming more concentrated by geography and/or market. And with this increased concentration, events on either side of that balance will have a larger impact than in the past, and the result is going to be increased price volatility.

Export of U.S. gas via LNG is also driving significant new demand. With Chenier’s Sabine Pass LNG Terminal now running two process trains (with Train 2 having come online in October 2016), the plant is currently consuming about 1.5 BFCD. Construction of Train 3 is substantially complete, and it’s expected to start full production in the next month or two, increasing gas consumption to more than 2 BCFD. With the start-up of Train 4 expected in late 2017, total gas demand at Sabine could exceed 2.5 BCFD by the end of the year. Taken together, incremental exports of U.S. natural gas via pipe and ship is forecast to add as much as 4-5 BCFD of demand by the end of 2017.

Marcellus and Utica development continues

Infrastructure development to move Marcellus and Utica gas to the north and west is continuing, reshaping the markets in the Northeast and beyond. With the massive increases in production from the Marcellus over the last several years and with the Utica field continuing to ramp up production, pipeline capacity in the region has been overwhelmed, creating huge bottlenecks and limiting transport out of the region. With gas often trading below $1 at the Marcellus regional hubs, lack of capacity was forcing many producers to delay new investments, including deferring completions of previously drilled wells.

However, with several new pipelines and expansion projects coming online in early 2016 and others beginning operations in late 2016 (such as the Algonquin AIM expansion and the Constitution Pipeline), the first full year impact of this new capacity will be felt in 2017. With more gas moving south and west, and with new capacity easing constraints into New England, the basis number is certainly going to be rewritten, and improving wellhead prices in the Marcellus region will incentivize producers to increase drilling and production.

Regulatory changes are already happening

Beyond the many operational developments, regulatory changes may also hit hard this year. The new Trump administration and Congress have already started following through on their various campaign promises to reduce regulatory burdens for U.S. businesses, including the energy industry.

In January, Congress acted to roll-back Obama-era regulations limiting methane gas emission by producers and pipelines, and, in only the second week of his administration, President Trump issued executive orders that signaled the beginning of the revision or elimination of most, if not all, Dodd-Frank regulations. Though his initial targets for revision are primarily aimed at bank fiduciary rules, Mr. Trump’s directive ordered the Treasury secretary to restructure or eliminate other provisions of the regulations to ensure they are in-line with his administration’s goal to improve the competitiveness of U.S. businesses in the global markets. Still, there is no clear indication yet as to whether the regulations most impacting energy traders – which include trade reporting and swaps rules – will ultimately be affected.

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