Mr. Market Delivers a Stacked Deck

An update on the short natural gas thesis

You don’t often get the chance bet against a 100-year event with good odds… but that’s the opportunity in today’s natural gas market.

Regular readers will recall my previous short gas thesis was based on a simple idea: U.S. traders have incorrectly extrapolated a legitimate gas shortage in Europe and Asia into the U.S. market. In reality, spiking global gas prices have almost nothing to do with the domestic U.S. gas market.

Before getting into current supply/demand dynamics, let me first address one of the key bullish rebuttals: liquefied natural gas (LNG) exports.

Bulls Get No Relief from LNG Exports

Yes, the rise of U.S. LNG exports has provided an outlet for U.S. gas into higher-priced overseas markets. But LNG exports require infrastructure. So regardless of whether global gas trades for $20, $50 or $100 - no new U.S. gas supply will get shipped onto the global market, without new export terminals.

The bulls will point towards a couple of new LNG export terminals slated to come online later this year or early 2022. These include Cheniere’s Train 6 at Sabine Pass, and Venture Global’s Calcasieu Pass, each on the Louisiana coast. These two new export facilities will provide about 2 billion cubic feet per day (Bcf/d) of new U.S. gas demand. The problem for the bulls is that supply will likely grow even faster, pushing prices lower throughout 2022.

That’s not my opinion, that comes from the EIA’s latest weekly update:

We expect U.S. production to average 96.4 Bcf/d in 2022, or 3.9 Bcf/d more than in 2021, and U.S. LNG exports to rise by 1.4 Bcf/d during this time period to reach 11.2 Bcf/d. We forecast that faster growth in production will put downward pressure on natural gas prices.

Therein lies the final puzzle piece - U.S. supply dynamics couldn’t be more different than those in Europe and Asia. In many parts of Asia, they simply don’t have the natural resource base to increase gas production. In Europe, strict environmental regulations, including an outright ban on fracking, has pushed European gas production into secular decline for the last four years.

Meanwhile, the U.S. sits atop an ocean of globally cost-advantaged shale gas. No, it wasn’t economic to flood the market with the stuff at sub-$3 prices in recent years. But at forward strip prices ranging between $3 - $4, shale drillers will gush cash flow. If supply won’t come from public E&Ps promising capital discipline, then you can count on the private operators - who control a big chunk of U.S. gas supply - to fill in the gap.

That’s a big problem for a market trading at multi-year highs, with only modest future demand growth through 2022, and starting from a position of excess supply in the present.

As I’ll show today, the U.S. gas market is clearly oversupplied on a weather-neutral basis. Anything less than a 100-year freeze event this winter, and prices have substantial downside to $3 - $4 in the weeks and months ahead.

Let’s start by reviewing the gas storage dynamics in today’s shoulder season…

U.S. Gas Market Oversupplied on a Weather-Neutral Basis

During the summer and winter seasons, weather plays a dominant role in short-term gas demand. Cold winter weather boosts gas consumption for heating, and extreme heat in the summer drives higher gas consumption for electricity (i.e. air conditioning).

You can cut through the weather-driven noise by focusing on the shoulder seasons, in the spring and fall. Weather anomalies play a much smaller role here, revealing a more clear picture on the weather-neutral supply/demand balance.

The chart below shows how the first shoulder season of 2021, in April - May, made quick work of reversing the winter storage deficit (created from the 50-year freeze event last February). Then, record summer heat followed by Hurricane Ida blew the deficit out once again.

Now that we’re in the shoulder season, the supply surplus driven by temporary weather anomalies is once again quickly reversing. This reveals excess supply in the U.S. gas market on a weather-neutral basis, just as we see during the April-May shoulder season:

Drilling down into the weekly EIA supply/demand data, we see further confirmation of an oversupplied market through the net supply/demand balance (i.e. total supply minus total demand). The chart below compares the net supply balance for the last four weeks of data versus the same period in 2020:

For more clarity, the chart below shows the difference between these two years in single bars, revealing an average surplus of 5.0 Bcf/d versus this time last year:

Add it all up, and today’s modest 174 Bcf storage deficit versus the five-year average can not justify $5.50 gas. The last time prices traded anywhere near current levels - back in November 2018 - the market was contending with an 800 Bcf storage deficit:

Most Scenarios Point to $3 - $4 Gas this Winter

Given the clear supply surplus on a weather-neutral basis, a warm weather would present a disaster for bulls. The storage surplus would likely eclipse the highs set in 2020, setting up the potential for $3 gas. Even a normal winter will still likely erase the deficit, which should easily send prices below $4.

Finally, a cold enough winter could deliver the long shot bulls need to bail out of their positions at a profit. But even a modestly cold winter won’t get the job done. We’ll need to see an extreme 100-year type of event, similar to the freeze event that hit the U.S. last February. But just one or two weeks alone won’t do it. This market needs a repeated series of harsh weather events to keep the weather-neutral surplus from rearing its head.

Sure, the 100-year storm could come and send gas to $10 or beyond. Anything less than that and substantial downside risks remain in today’s gas market.

That’s the kind of stacked deck I like to play with. When the market gives you good odds to bet against the 100 year storm, it typically pays to take it.

As always, risk management is key for trading winter natural gas. Admittedly, my original short thesis was a few weeks early. Cutting losses early keeps you alive to fight another day.

The supply/demand fundamentals have only grown more bearish in the last several weeks. That’s why I’m taking another shot at current levels.

Disclaimer: For informational purposes only. Nothing presented here should be considered investment advice or a recommendation to buy/sell any financial instrument. Always perform your own due diligence before buying/selling any financial instrument. Any investment carries risk of loss.