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Natural Gas Stocks Ride Upcoming Wave of Oil Well Closures

Streetwise Reports, Streetwise Reports
0 Comments| May 15, 2020

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2019 was such a rough year for natural gas that by the time February 2020 rolled by, hedge funds had built up the largest net short position on record for the sector. Those investors have suddenly developed a strong appetite for natural gas stocks and bonds on the expectation that U.S. oil wells that generate gas as a by-product will close fast enough to make up for the collapse in global natural gas demand. Some Appalachian gas producers are especially well-positioned to benefit from such a prospect.

Global consumption of natural gas is on track to drop by 5% in 2020, according to the International Energy Agency (IEA). While that number sounds harmless, it represents a huge shock to the gas industry which has enjoyed ten years of uninterrupted demand growth, until the COVID-19 lockdowns brought that streak to an end.

Early evidence of the impact has already cropped up in the first quarter data, even though the lockdowns in Europe and the United States were still relatively new. While global demand fell more than 3% in 1Q 2020, demand in the United States dropped 4.5% from a year earlier, dragged down by an 18% decline in residential and commercial demand. For context, the last time U.S. gas demand contracted to this extent was during the Great Depression, when domestic demand tumbled by 13% in 1931 and by 7% in 1932.

Worsening Demand/Supply Imbalance

Although demand has experienced a historic plunge, supply has not been adjusted downward to match that plunge. In fact, the demand/supply imbalance that weighed on natural gas prices last year has only worsened. Natural gas inventories in the United States stood at 2.210 trillion cubic feet on April 24—up 783 billion cubic feet from a year ago and 360 billion cubic feet above the five-year average, according to the EIA. In other words, U.S. gas stockpiles are 55% higher than a year ago and 20% higher than the five-year average.

The biggest challenge to adapting output lies in the fact that turning the taps off at typical gas fields isn't easy. Moreover, those that can be stopped take time and money to restart, says the CFO of InfraStrata Plc, a U.K. firm focused on the development and commercialization of advanced energy infrastructure.

Almost Out of Storage

Back in April, MRP wrote about the sudden wave of oil storage demand that's been boosting the oil tanker market. It so happens that gas storage sites are also filling up quickly due to growing stockpiles of the commodity. Unless a major change occurs in the near-term, Europe could run out of storage space for its natural gas by July, or even earlier in some markets, according to industry players.

Speculators Flip from Bearish to Bullish

Some investors are already betting that the near-term change will be supply-driven, and that it will originate from the same place that, years ago, seeded the conditions that would eventually grow into today's natural gas glut. When oil prices plunged into negative territory last month, the US energy industry received a wakeup call. Better to start shutting off money-losing wells, they realized, than to have to pay traders to get rid of the oil.

More than 12% of U.S. gas output is “associated gas”, extracted as a byproduct of oil drilling. Less oil drilling means less associated gas, which effectively equates to a supply cut. The notion that there may be less shale gas coming from U.S. oil wells this year has prompted the fast money set to reverse their bearish bets on the commodity and its producers. In mid-February, hedge funds and other speculators were piled into the largest net short position on record for natural gas. Now, those same investors are net long for the first time since May 2019.

Beyond April's 26% Natural Gas Price Surge

Such a dramatic shift in sentiment has helped pushed the price of U.S. natural gas 26% higher in one month—from $1.55 per million British thermal units (MMBtu) on April 2nd to $1.96/MMBtu on May 4. Despite those gains, the commodity's price is still 10% lower than at the start of the year when it was trading at $2.17/MMBtu.

The question some investors are asking is whether these ultra-low prices will compel enough utilities to switch out of alternate power sources into natural gas, triggering a demand-driven price surge in the process. The IEA's forecasts for 2020 also shed some light on this matter.

As mentioned earlier in this report, the Paris-based agency which advises nations on energy policy estimates that global natural gas consumption will fall by 5% this year. Should the world economy recover faster than anticipated from the COVID-19 disruptions, the overall demand loss could narrow to about 2.7%, which would still mark the first annual drop in natural gas consumption since 2009. Much of the decline is expected to come from power generation.

The IEA has also projected that all sources of energy—i.e., oil, coal, natural gas, and nuclear—will see a decline in demand this year, with the exception of renewable energy. That's because renewables in many countries get first priority to feed electricity into the grid, enabling them to maintain or increase market share when there's a huge plunge in overall energy demand.

The energy source most at risk of losing market share to natural gas is coal, which is heading for its biggest fall in annual demand (-8.0%) since World War II. The fact that coal's share in the electricity mix has fallen in India, China, Europe, and parts of the U.S.—four regions with large and varied electricity markets — implies there is more pain ahead for this commodity. Based on the IEA's figures, any market share losses to natural gas are not enough to push the latter's overall growth into positive territory this year. This means, there likely won't be a demand-driven surge in the price of natural gas, unless the recovery from coronavirus delivers an upside surprise.

How to Invest

Investors can gain exposure to movements in the price of natural gas via the United States Natural Gas Fund, LP (UNG), which holds near-month contracts in natural gas futures. Those looking for exposure to natural gas equities can use the First Trust Natural Gas ETF (FCG) as an investment vehicle. FCG tracks an equal-weighted index of US companies that derive a substantial portion of their revenue from the exploration & production of natural gas.

Given that the world is awash in natural gas, it could take a while for the market to rebalance itself, which means there is limited upside for the UNG in the near-term. Any positive headlines, however, would have a bigger impact on FCG. That's because natural gas producers have struggled with declining gas prices for 10 years, during which time their stocks have gotten hammered, losing 92% of their value.

The closure of oil wells in the Permian and North Dakota regions could be especially beneficial to gas-focused companies operating in the Appalachians, since they will be able to capture a greater share of the market by default. Some of these companies—including EQT Corp (EQT), Range Resources Corp. (RRC), and CNX Resources Corp. (CNX)—saw their share prices more than double during the month of April. Those gains helped the FCG deliver a return of +51% last month. There is room for the Appalachian gas stocks to climb higher, since they are rising from a very low base.

This content was delivered to McAlinden Research Partners clients on May 4. To receive all of MRP's insights in your inbox Monday - Friday, follow this link for a free 30-day trial.

McAlinden Research Partners (MRP) provides independent investment strategy research to investors worldwide. The firm's mission is to identify alpha-generating investment themes early in their unfolding and bring them to its clients' attention. MRP's research process reflects founder Joe McAlinden's 50 years of experience on Wall Street. The methodologies he developed as chief investment officer of Morgan Stanley Investment Management, where he oversaw more than $400 billion in assets, provide the foundation for the strategy research MRP now brings to hedge funds, pension funds, sovereign wealth funds and other asset managers around the globe.

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