Prior to COVID-19, natural gas was typically an afterthought in the commodity markets. Global supplies were plentiful, thanks to growth in U.S. exports, and gas was often viewed as a byproduct of U.S. oil drilling. How times have changed. Forward U.S. gas prices for the next 12 months have increased 77% year-to-date with comparable European contracts up 178%.
This dramatic change is being driven by structural shifts that have rendered both supply and demand more price inelastic. Regarding U.S. supply, the reduction of oil drilling has lowered associated natural gas production while consolidation and capital discipline have constrained drilling. The gas rig count has not responded to higher prices, and management teams are communicating the status quo into 2022. Additionally, due to restrictions on pipeline construction, key sources of supply face limitations on delivering additional production to market. On the demand side, retirements of coal plants have reduced gas-to-coal switching in power generation as a balancing factor. Liquid natural gas (LNG) exports have increased and are unlikely to slow given elevated global prices.
Outside the U.S., these factors are even more pronounced. The shift away from coal is driving secular demand for gas, and climate policy in Europe has created a virtuous circle where gas and carbon drive each other higher as gas-to-coal switching creates additional demand for carbon allowances. Incremental supply is inelastic as new LNG supplies are part of long lead time projects. Given below-average inventories, there is a credible scenario that a colder-than-normal winter will require demand destruction from industrial customers to balance the market. U.S. consumers are better positioned than European and Asian peers, but the impact on supply chains could be meaningful.
While we don’t anticipate persistent shortages, the trends are likely to remain intact over the long term. Efforts to decarbonize create reliance on natural gas to help displace higher-emitting energy sources and support intermittent renewable power, while more extreme weather due to climate change increases the criticality of reliable, dispatchable power. These factors are supportive of non-investment grade credits exposed to the natural gas value chain. Tight global markets will drive incremental U.S. LNG projects, supporting domestic demand. Combined with upstream capital discipline, this should drive marginal U.S. gas prices higher and credit improvement for gas producers. Higher domestic production, constrained pipeline availability and a focus on system reliability support cash flows and valuations for pipeline operators. Winter may be coming but the secular outlook for gas credits is bright.