Is Natural Gas the Beneficiary of Lower Oil Prices?

04/24/20 | Michael Laitkep

Before oil prices fell off, US natural gas prices were already weak, with gas producers shifting toward maintenance capital spending and reducing growth in the second half of 2019. In recent weeks, oil-focused E&Ps have responded to the lower price environment by cutting growth capital spending, and drilling activity has plummeted (read more). Associated gas, which describes natural gas produced by oil wells, has been a major driver of growth in natural gas production in recent years, contributing to the oversupply that has depressed prices. Associated gas production is likely to decrease in oily basins as a result of potential shut-ins and natural production declines as a well matures. On Kinder Morgan’s (KMI) earnings call on Wednesday, management said they expected shut-ins to occur with the Permian and Bakken among the most impacted areas. As shown in the chart below, the Energy Information Administration (EIA) expects US marketed gas production to decline 8.8% from March 2020 to March 2021 before beginning to rise in 2Q21 as gas prices are expected to recover.

One potential silver lining of gas production declines is higher natural gas prices over time as the market rebalances. The Henry Hub natural gas benchmark price has traded below $2 per million British thermal unit (MMBtu) for most of 2020 as a result of oversupply concerns due to production growth and above average inventory levels as well as demand uncertainty related to the coronavirus more recently. According to the EIA’s most recent Short-Term Energy Outlook, the price of Henry Hub natural gas is forecasted to increase to an average price of $2.11/MMBtu in 2020 and $2.98/MMBtu in 2021 as a result of lower gas production and an improving demand outlook toward the end of this year. Notably, the average 2021 price was revised higher 19% over the price forecast from March of $2.51/MMBtu. The EIA’s projection aligns with the Henry Hub forward curve, which reflects stronger pricing in 2021. Considering prices for the full year, the average forward price is $2.35/MMBtu for the rest of 2020 and $2.74/MMBtu for 2021. To quantify the price improvement further out on the curve, the January 2021 natural gas contract price has increased from a year-to-date low of $2.46/MMBtu as of February 28 to $3.09/MMBtu as of April 22. Over the same time period, the WTI contract price for January 2021 has declined from $46.00 per barrel (bbl) to $29.77/bbl.

The implications of natural gas prices and production for midstream companies depend on the timeframe being examined. In the short term, a depressed pricing environment and declining volumes are challenging, especially for gathering and processing companies with greater exposure to the wellhead. For these companies, the focus will remain on taking steps to maximize financial flexibility. In contrast, midstream companies with a high percentage of fee-based cash flows under take-or-pay contracts and those with exposure to demand-pull pipelines are better positioned to withstand potential volume declines. KMI’s release this week provides some clues as to how natural gas transportation is holding up in a tough environment. KMI’s Natural Gas segment EBDA guidance was lowered by 4% over its initial budget for 2020 compared to a reduction of 17% for its Products segment, which includes refined products pipelines and terminals. Based on adjusted segment EBDA, KMI’s gas business consists primarily of pipeline transportation, including 74% interstate pipelines and LNG, 14% intrastate pipelines, and 12% gathering and processing. While natural gas fundamentals are challenged at the moment, the outlook for natural gas could be improving as lower associated gas production helps to rebalance the market. For midstream companies with assets that transport or process dry gas production in the Northeast and Haynesville, higher natural gas prices could improve the drilling outlook for these areas toward the end of this year or early next year. While the current natural gas outlook remains challenged in the short term, there are reasons for some optimism looking forward.