As the price of natural gas continues to hover around its lows for the year, it looks like the economic principles of supply and demand are starting to take effect in the market.
The U.S. EIA recently found that production from seven major shale basins in the U.S. should start to drop quickly after reaching an all-time production high in May. The seven basins produced a total of 45.6 billion cubic feet per day of gas in May, but that figure should drop 1.5 percent by September. Of the seven basins, only Utica will post an increase in production.
The drop in supply is largely a result of slow depletion from legacy wells combined with a decline in new wells being drilled. With natural gas prices and oil prices still at very low levels even after the small rebound last week, producers simply do not have much of an incentive to drill new wells. The volatility around energy prices is also playing a role, as it makes it harder for companies to plan and properly hedge production.
This is good news for the markets though. To the extent that demand growth is weak, and there has been a glut of gas recently, the EIA data suggests that the markets are starting to sort themselves out. As production falls, prices should rise a bit until producers can make a profit by drilling new wells.
Despite the prospect of falling production, natural gas prices and stocks have yet to really respond. Even the EIA is starting to revise its price expectations upward. Of course no one is expecting natural gas prices to come back to $4 per million Btu (MMBtu) anytime soon, but for stock market investors, the price trend is starting to head in the right direction. If producers continue to throttle back on production, stock prices should start to see appreciable gains before the end of the year from current levels.
Both short-term and medium-term, natural gas producers are probably in a better place than oil producers. On the one hand, demand is a mixed bag. It is not rising quite as much as once predicted, but with more power plants switching from coal to gas, consumption will continue to pick up. With energy demand more or less stagnant or at best slowly growing in the U.S., natural gas demand increases need to come primarily from taking share from other existing fuel sources. The EPA’s greenhouse gas rules will continue to force coal to shrink, to the benefit of natural gas. More natural gas consumption will push up prices.
Also, LNG export facilities will begin to come online – Cheniere Energy (NYSE:LNG) expects to bring the first major American LNG export facility online by the end of this year. More exports should provide a demand pull for natural gas drillers.
Meanwhile, the contraction on the supply side should help the producers that are the fittest and best positioned. As fewer wells are drilled and the highest cost production is forced out, prices will inevitably rise. Investors should position themselves now to take advantage of future production declines and the resulting price increases.