Market Newsletter – May 2020May 01, 2020
“Give me six hours to chop down a tree and I will spend the first four sharpening the axe.” – Abraham Lincoln
In last month’s article, I wrote at length about a confluence of events that have led to an upending of several energy market fundamentals. Some of these events were abrupt and unforeseen (COVID-19 demand destruction, OPEC+ production adjustments, global economic collapse), while others have been gradually emerging in response to sustained market conditions and price levels (E&P capex cuts, divestment, reduced drilling activity). Irrespective of the subject, Heraclitus was spot-on – change has been the one constant we have been able to count on 2020. With so much uncertainty being cast upon just about every aspect of our daily existence nowadays, prudence beckons us to simplify the conversations, focus on what we do know, what we can do with that knowledge, and utilize each faculty to affect and shape the future to the extent possible.
Here is a simple truth that cannot be changed, altered, or impacted by a novel virus, Russian oligarchs, nor active drilling metrics – the axial tilt of the earth as it orbits the sun is now oriented in such a fashion that the summer season is almost here. In fact (it feels good to declare), the summer solstice approaches in a mere matter of weeks (June 20th), and summer has almost completed the full transition of its warmth from one part of the blue planet to the other, the Northern Hemisphere. Another fact: when temperatures rise, so too, does cooling demand (a demand which is filled by electricity generation). The fuel source for generation to meet cooling demand varies by locality, but there are six available sources for utilization: natural gas, coal, nuclear, wind, solar and hydroelectric. Nuclear baseload and hydroelectric (35%) are fairly stable baseload sources for generation, solar (2-4%) and wind (10-15%) will vary on weather patterns, while natural gas (38%) and coal (17%) fill in the blanks based on the price of each. With natural gas prices down 28% year-over-year and coal production slumping and powerplants being retired, the balance at baseline strongly favors natural gas at this time. Under normal circumstances, when natural gas is the favored fuel-switching source of generation (called powerburn), it can play a large role in the supply/demand balance that exists in the natural gas market. However, these are not normal circumstances in the natural gas market, as we know that natural gas production has been steadily losing growth since the beginning of the year. It remains to be seen exactly how much of an impact powerburn will have on a natural gas market that is already structurally undersupplied, but early data suggests that powerburn could be in for a record-setting summer. Even with depressed demand levels from both COVID-19 and mild weather, powerburn in May has exceeded year-ago levels (as much as 8.9% higher). Put simply, we are using more natural gas nowadays to meet less electricity demand, while that same supply source is shrinking on a weekly basis. This summer could very well exacerbate the undersupplied conditions – coupled with falling production and rebounding industrial/commercial demand, strong powerburn could result in a steady, if not dramatic, tightening of the natural gas supply/demand imbalance over the next few months – even with continued lackluster LNG export demand.
We also know that, like the seasons, natural gas reserves and prices retain seasonal, cyclical elements. One of the most interesting and telling relationships that exists is between the respective levels of each: year-over year change in reserves vs. next-year price. We have never seen a period in recorded natural gas history in which a rise in stocks year-over-year wasn’t immediately followed by a strong increase in price. The current year-over-year increase in natural gas inventories has been hovering around 800-900 Bcf. Historically speaking, when we have seen inventories build at the pace we are currently seeing, on average natural gas rallied by 52% over the next year. Granted, at lower levels (400-750 Bcf surplus), the average rally has been closer to 16% – as of last Thursday, inventories were 778 Bcf higher than a year ago, right on the precipice of each tranche. Either way, on the surface, this seems counterintuitive to supply/demand economics; prices are supposed to go l ower when a commodity is more widely available.