The dual black swan events of the COVID-19 pandemic and oil price war have created a unique analytical opportunity within petroleum products. As oil prices crash, the natural gas prices have largely remained unchanged. This is due to the markets in which the commodities are used. Transportation which is the main use of oil has almost entirely stopped, whereas electricity generation and heating, the destination for most natural gases has remained similar to pre-2020 levels. The market has priced these assumptions relating to production and usage demand into the futures prices showing the oversupply of natural gas is expected to correct faster than that of crude oil. Factors for these assumptions include the sources allocated to electricity generation, changes in electricity usage and demand due to COVID-19, anticipated oversupply for crude products like fuels, and anticipated production decline for crude, NGL, and natural gas due to current market forces.
The COVID-19 pandemic has all but shut the world down and is showing no signs of global relief. It does not matter how cheap oil is if people are not driving, flying, or consuming anything aside from the bare essentials – there is no demand boost from low prices. With crude demand disappearing all around the world, oversupply on the market has run rampant. Luckily for the natural gas sector, such dramatic demand declines are not being felt across the industry. This is due to the fact that a majority of crude oil is utilized in transportation (an industry hit hardest by the pandemic) while a majority of natural gas consumption is used in power and heat generation (an industry only slightly affected). As a result, the strip price for natural gas is showing larger percentage increases than crude or NGLs because the market is pricing in the assumption that continued electricity demand will not fall as quickly as the oversupply of natural gas.
Average Electricity Generation Allocation in the U.S. – Past to Present:
Dating back to the 1950s, coal was the leading source of electricity generation in the United States. Coal sat alone atop the electricity industry until 2016 during the Obama administration when natural gas took the majority share in domestic electricity generation. As gas emits half the CO2 as coal, coal factories began to shut down in favor of its more environmentally friendly cousin. While natural gas was responsible for 38.4% of the electricity generation in 2019, the 28.5% generated by coal will eventually be taken over by a mixture of renewables and natural gas in the short term as it is much cheaper than nuclear . By comparison, a nuclear power plant costs $5,366 per kilowatt of capacity to build, a wind farm costs $1,980 per kilowatt of capacity while a new gas plant only costs $912 to construct for the same kilowatt of capacity . Since coal has continued to follow the downward trend seen in Figure 1, new electricity sources are mostly coming from solar, wind, and natural gas. Coal is on the way out, and due to its environmentally friendly and cost-effective nature, natural gas will take over for years to come. Power generation will generally trend towards the resource with the lowest operating cost and by association lowest price, which is another reason renewables and natural gas are continuing to play a bigger sourcing role than coal.
Fossil fuels (primarily natural gas) will dominate the energy sector over the next fifty years, while renewables (mainly solar and wind power) will continue their upward trajectory before leveling off mid-century. According to the EIA’s annual Energy Outlook, energy sources such as wind and solar have grown quickly thanks to aggressive policies and subsidization, but such subsidies are projected to run out and slow the rate at which renewable sources grow . If the damage from COVID-19 is great enough, there will not be a ton of free cash flow or incentive to invest in clean energy and policy will turn toward the cheapest option that will continue to generate clean energy into the future.
Historic Usage and Projected Drop in Electricity Demand:
Natural gas consumption in the United States is shared amongst the electric power, residential, industrial, and commercial sectors (Figure 3). Moreover, due to power plant technological improvements and competitive natural gas prices, the electric power sector has accounted for the largest share of natural gas consumption in the last decade. Temperature, on the other hand, also largely drives annual fluctuations in natural gas consumption. During the winter, consumption levels are at their highest in the residential and commercial sectors since natural gas is the predominant fuel for heating across most of the U.S (except in the East coast where heating oil is predominately used) . In the summer, however, relatively high temperatures increase electricity usage, as demand for air conditioning increases.
Electric power consumption from natural gas historically shows an increasing trend in the period from 1997 to 2019 (Figure 4). In 2019, according to the EIA, electric power accounted for about 35% of total U.S natural gas consumption . The 2020 projection for natural gas electricity consumption is currently estimated at 31.3 Bcf/d . This remains uncertain and largely skewed however given the COVID-19 pandemic which has forced businesses to shut down and caused most people to stay home to work. The question then becomes – given that the electric power sector represents the largest share of natural gas consumption, how likely is it to be impacted, and how significant will the drop in consumption from the residential, commercial, and industrial sectors be?
The April 2020 EIA short term energy outlook is forecasting a decline of electricity retail sales in 2020 of 4.7% for the commercial sector, 4.2% for the industrial sector, and 0.8% for the residential sector . This is a total electricity retail sale decline of 9.2% in 2020. Empty commercial and industrial buildings may not be consuming as much electricity, but essential businesses are still operating and commercial buildings are still consuming a baseline level of electricity for necessary operations such as heating and cooling, vampire power (a.k.a. standby power), security systems, and other essential systems. While retail sales in 2020 are expected to decline by 9.2%, power generation is only expected to decline by 3% over the same period with coal power generation falling by 20%, natural gas generation rising by 1% and renewable generation growing by 11% . It should be noted that the allocation decline and growth percentages are for each individual source and not the total electricity generated.
Projected Commodity Strip Prices:
There will be a drop in demand for natural gas as the coronavirus pandemic greatly reduces commercial electric power and heating consumption. Lockdown orders forcing society to shelter in place will increase residential consumption and help buffer that blow. The market recognizes the demand declines experienced in the natural gas sector will dwarf in comparison to the destruction of the crude oil and associated liquids markets. With decreased travel creating increased gasoline, ethanol, and jet fuel supplies, crude demand will be unable to correct oversupply as quickly as natural gas. In order to predict the market’s faith in these commodities, data from the CME Group on futures pricing was compiled to compare future commodity strip prices (Table 1) .
The projected data uncovers market assumptions showing that natural gas is expected to recover from the pandemic and stabilize far sooner than the crude oil and NGL markets. The change in strip pricing for crude futures between May 2020 and February 2021 projects a 38.81% increase. Natural gas futures over the same period show an astonishing price growth of 77.97%, resulting in a natural gas futures growth of 38.62% over crude oil. Some of this change is due to natural contango in the futures markets where futures prices are always greater than the spot price, however if this were the only price factor the percent change between commodity streams would be relatively similar. This shows the market is expecting the oversupply in natural gas to be offset sooner than the oversupply in crude oil. There are several reasons for this assumption. The most prominent reasons are that consumption of natural gas products have not degraded as sharply as fuel created from crude oil, and as market forces cause the shut-in of uneconomic oil wells the associated gas production will also cease. This associated production is a major factor in the gas oversupply since it can sometimes be two to six times the gas-oil ratio (Mcf/Bbl) for a barrel of oil produced. As NGLs are a product of wet natural gas and used highly in the electric power generation and heating industries as well as transportation, the data shows there is also faith for a stable price rebound in the NGL market soon.
NGL and Natural Gas Yields:
As seen in Figure 5, NGL production has increased across all regions since 2012 with the largest increase coming from the Northern Appalachian region (Marcellus and Utica Shale), where production increased from 43,000 b/d in 2012 to 512,000 b/d in 2017 . Similarly, NGL production has doubled in both the Permian Basin and the Eagle Ford play from 2012 to 2017 and has more than tripled in the Bakken. Natural gas production continues to grow with withdrawals in the Appalachian region increasing from 28.6 Bcf/d in 2018 to 32.1 Bcf/d in 2019 . For this area, Pennsylvania had the largest annual increase in gross withdrawals of natural gas, increasing by 2.1 Bcf/d in 2019 to reach 19.1 Bcf/d. Nationally, Pennsylvania’s annual change was second to that of Texas, where gross withdrawals increased by 3.6 Bcf/d to a record annual production of 28.0 Bcf/d. Texas’s increase in natural gas production is mainly from development in the Permian Basin and Haynesville shale formations.
Gas plays are slowing production because of higher-than-average natural gas inventories and prices lower than $2/MMBtu. In the coming months, U.S. natural gas production is expected to decline, leading to a decrease in the gas market oversupply as we enter winter 2020 and into 2021. Output will drop the most in the Appalachian region because of low natural gas prices and in the Permian region, where low oil prices are forcing producers to cut production, thus reducing associated gas and NGL output from oil wells.
Despite the citizens of the world staying home and contributing to more residential electricity demand, it has not offset the decrease in other forms of electricity demand as commercial buildings, factories and other large electricity users slow or stop operations reducing their power and heating needs. Overall, retail sale electricity demand is projected to fall 9.2% in 2020, but power generation is only expected to decline 3%, which will result in a 6.2% net power demand oversupply. Since natural gas makes up around 40% of electricity generation, about 2.5%, or 0.78 Bcf/d, of the net oversupply will be allocated to natural gas. Due to current low commodity prices, gas production will naturally drop which will be magnified by the reduction in associated gas as oil wells are shut-in and capital budgets continue to be slashed. With gas production expected to fall by 7.3% in the next nine months, about 2.8 Bcf/d of the 7 Bcf/d decline would have supplied power generation. Pair this with storage expected to decline from peak winter season usage, the natural gas oversupply will correct faster than the decrease in electricity demand from lockdown orders. Finally, without as much travel resulting from the coronavirus, fuels generated from oil and NGLs will have decreased demand and the liquid oversupply will not be able to come back into supply and demand balance as fast as natural gas. Since NGLs are a byproduct of natural gas and both contracts are sold in $/MMBtu, increased prices for a British thermal unit will affect the contract value of both commodities.
As a result, the market has built these assumptions into futures pricing which can be seen from the 77% change for contracts in natural gas and a 74% change for NGL contracts between May 2020 to February 2021. This increase is disproportionate compared to a 39% change for crude oil contracts in the same period showing the demand imbalance for travel fuel compared to electricity and heating.
Much of the data represented in this piece was compiled and evaluated before the energy markets went into free fall on April 20th. When the May contract cratered below zero, we believe the market priced in an assumption for more oil production cuts than when the April 15th data (which is also reflected in current natural gas and NGL futures prices). For this reason we used an average futures price for the May 2020 contract compared to recent strip prices. Due to current commodity volatility in recent days the prices and percentages have changed, but the same underlying principles apply from this analysis that the market is still pricing in production cuts compared to supply for natural gas.