Last year we discussed our growing optimism about the natural gas commodity. While our thesis had merit; the reality of a warmer winter, especially in Europe, derailed our bull case scenario. Longer term, our thesis has not changed much. We still believe that natural gas is growing from a regional commodity to one where growing demand in emerging markets will facilitate a truly globally traded commodity. We thought that now would be a good opportunity to review what went wrong in the last ten months and why we remain bullish on the future.
A Brief History of Natural Gas
Historically, natural gas has been a regional commodity. Most countries that produced it, consumed it domestically. For example, North America was a regional natural gas market for decades. Production was primarily consumed in the United States with some cross border trade with Mexico and Canada. The chart below illustrates the wide divergence in regional gas prices in the United States on December 29, 2022. Prices in Los Angeles were over $15.00 per mcf while natural gas was negative in the Permian Basin. Operators in the region essentially paid midstream companies to accept their natural gas. While this was primarily due to a pipeline outage between West Texas and the West Coast, these sorts of regional differences have historically occurred frequently, due to a number of structural factors.
Before the emergence of the shale revolution, the concern was that the United States would face a deficit of natural gas for domestic consumption. Liquefied natural gas (LNG) was purchased from Australia and the Middle East at significantly higher prices to make up for a lack of domestic supply. With the advent of the U.S. shale revolution, the United States quickly faced a glut of supply. In short, the U.S. oil and gas sector became so proficient at finding and developing natural gas, that the domestic market became swamped, and prices plummeted. As a result, the U.S. transitioned from an importer of LNG to an exporter in less than a decade.
LNG is not a new technology. Essentially, natural gas is rapidly cooled to a liquid state (liquefaction). It is then shipped to end users where it is reheated and sold in a gaseous state (regassification). The technology has existed for decades and cargoes were primarily purchased for the purpose of generating electricity by utilities in countries with a dearth of hydrocarbons, the most noticeable being Japan. There was minimal need for LNG shipments to other regions for a host of reasons, but the biggest was that power generation globally was mostly supplied by coal. As environmental concerns began to emerge, natural gas power generation plants began to replace coal fired plants in Europe and the United States. This was great for all parties involved. Dirty coal was replaced by relatively clean burning natural gas, which was readily available. As a result, CO2 emissions declined dramatically. Utilities had more energy efficient, often cheaper, and more readily available and reliable fuel for growing electricity demand. While environmentalists may not have been enamored with natural gas, they could not dispute the positive effect it had by replacing coal.
LNG and the Advent of The Global Commodity
As natural gas replaced coal for power generation, LNG markets began to grow, with countries with an abundance of supply exporting to markets with an abundance of demand. Asia continued to be the leading importer, but Europe also began to accept growing amounts of cargoes.
With the Russian invasion of Ukraine, we are now witnessing the emergence of a truly global natural gas market. Pre-invasion, Europe imported almost 42% of its natural gas supply from Russia.[1] Sanctions on the Russian government and the sabotage of the Nord Stream subsea pipeline created a dramatic shift in the European market. One of the only significant sources of readily available supply was LNG. As a result, the price of LNG cargoes quickly skyrocketed to over $70.00 per mcf as European buyers openly bid for spot cargoes against buyers in Asia. U.S. natural gas prices also increased to almost $9.00 per mcf.
Last fall, we believed that this increase in international natural gas prices would continue through winter and, at the same time, cause U.S. gas prices to rise. While this did happen through the late fall; by January it was apparent that Europe would enjoy a warmer winter than expected, thereby reducing natural gas demand. This was aided by reductions in industrial, commercial and residential demand. As a result, international natural gas prices moderated from extreme levels and U.S. natural gas prices plummeted back to the $2.00/mcf range. This was also aided by a fire at the Freeport LNG export facility in Texas which reduced North American LNG supply by 2 Bcf/day, which remained in the U.S. domestic market.
Where Do We Go From Here?
Looking ahead, we believe our long-term thesis holds merit, as the fundamentals of a global natural gas market remain intact. North America, the Middle East, and to a lesser extent Australia, face a glut of supply relative to regional demand. Exports of LNG should continue to move towards regions such as Europe and Asia, and increasingly India and Latin America. As we believe that coal will continue to be replaced as a source of electricity in many parts of the world, natural gas is one of the most readily available and cheapest replacements. Longer-term, we believe that the price for LNG cargoes will reset at a higher level than historically. This should in turn, establish a higher floor for U.S. natural gas prices.
For now, we are invested in LNG companies and midstream operators in the United States. Both groups receive fees for the molecules moved through their assets and have minimal commodity exposure. At some point, we will become more bullish on U.S. natural gas producers, but for now, the North American market has ample supply.
Disclosures
LIM is a Registered Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
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