It came as no surprise that, as oil demand and prices collapsed during the coronavirus pandemic, natural gas prices did the same. The surprise came in a puzzling exception to this trend. As prices fell dramatically in Europe and Asia, US prices remained relatively steady, even rising at times. Mark Finley and Anna Mikulska of Rice University’s Baker Institute for Public Policy recently laid out the puzzling phenomenon and its potential implications, including erosion of US competitiveness in the global market for liquefied natural gas (LNG).
According to Finley and Mikulska, even marginally higher domestic prices at a time when global prices collapse can erase whatever competitiveness remains for US LNG exports against other suppliers. In fact, European spot prices of LNG have matched the level of Henry Hub prices at times.
The flexibility of US LNG contracts that allow for cancellations exacerbated the situation. As a result, US net natural gas exports fell by nearly half between March and August, due almost exclusively to a 54% collapse in exports of LNG.
Why Did US Prices Rise?
“The IEA estimated earlier this year that natural gas demand would fall by 5%; here in the US, the EIA expects it to fall by about 2%. Lower demand should equal lower prices. Why not this time?” asked Finley and Mikulska in a column posted online. One reason, they said in answer to their own question, is that, according to the US Department of Energy (DOE), US natural gas supply will fall more rapidly than demand. One reason for that is shale.
As US crude production soared during the shale revolution, so did natural gas liquids (NGL) output as an associated byproduct. Since 2006, the share of associated gas in total US production has roughly doubled. And, according to the Energy Information Administration (EIA), in 2018 and 2019, most of the growth in US natural gas production came from associated gas.
At the same time, plays in which natural gas constituted almost the entire output have been the least profitable in recent years as returns on natural gas were much lower than those on crude or NGL. Before the pandemic, there were more than six times as many rigs looking for oil in the US than for natural gas.
When oil prices briefly went below zero in late April, US oil production collapsed. Unable to cover their operating costs, US producers shut in more than 2 million B/D of production in May—the sharpest decline of US production ever seen, according to the Baker Institute.
As oil production collapsed in the US shale plays, so did associated gas production. US crude production fell by nearly 20% between March and June, while natural gas production fell by about 10%. Production of both has recovered since then but remains significantly below prepandemic levels. As of August, US crude oil output remained more than 15% below March levels; the decline in natural gas output has moderated to approximately 5%.
For example, oil-focused shale plays such as the Permian, Eagle Ford, Bakken, and Niobrara, which accounted for approximately 40% of shale-related natural gas production before COVID-19, accounted for more than 80% of the pandemic-related decline in gas production, according to the EIA. In contrast, production in the main gas-focused shale play—“Appalachia” in the DOE data, largely the Marcellus—has remained relatively flat and is slightly higher now than it was before the pandemic.
What this means for natural gas prices, according to the Baker Institute, is that, when gas is produced in association with oil, the economics are largely driven by the economics of oil. When oil prices do not support production, associated natural gas production also stops, with little to no consideration of natural gas prices. Less gas production in oil shale plays could result in either increased production elsewhere or higher prices. The latter is what occurred in the US. The gas-focused rig count has fallen along with the oil rig count since the pandemic broke out.
Ethane Plays a Role
Another interesting wrinkle, say Finley and Mikulska, occurs in NGLs on the spectrum of hydrocarbons between natural gas and crude oil. These lighter liquids are generally separated from natural gas and sold because they tend to have higher value. But that’s not always the case. At times, ethane, the hydrocarbon closest to methane, can be left in the natural gas stream in a condition known as ethane rejection because of economics or processing bottlenecks. There is some evidence that ethane has been shifting between the oil and gas streams this year. While DOE monthly data show that production of both crude oil and natural gas is lower now than before the pandemic, ethane production in the country’s NGL stream has actually increased, indicating that some ethane volumes are being pulled from the natural gas stream (where it is counted as natural gas) and into the liquids stream (where it is counted separately). This also contributes to reduced natural gas supply in the US.
What Can We Learn From This?
The pandemic has revealed that much of the cheap legacy supply of US natural gas depends on incentives for crude oil production. This may provide a clue for future domestic gas pricing dynamics.
Oil and gas prices have been recovering globally alongside economic recovery, aided in the case of gas by typical seasonal increases in demand. Preliminary data also suggests that LNG exports have begun to recover more recently. But the persistent, relative strength of US natural gas prices and its implications remain worth watching.
Without support from associated gas production, says the Baker Institute, US natural gas prices may need to rise to incentivize gas-focused drilling. In the short-term, this has affected the competitiveness of US gas exports, and, if prices are high enough, it could justify return of some of the coal generation that has recently been lost to cheap natural gas. A growing global focus on climate change and prospects for a potential decline in oil consumption and production in the US and globally may hold the same implications for natural gas pricing over the longer-term.
