Natural Gas Prices at an Unsustainable Low

Dave Meats: After an updated look at supply costs, we have lowered our marginal cost estimate for U.S. natural gas to $2.80 per thousand cubic feet, from $3 previously. But that's still pretty bullish at current prices--the futures curve is currently averaging only $2.60 per mcf in the next four years. In other words, we think U.S. natural gas prices have fallen to an unsustainable low.

There are two main concerns for investors, and we think both are overblown. First, there’s the idea that associated gas from oil-directed drilling in oil plays like the Permian Basin is flooding the market and pushing down prices. It’s true that associated gas production has grown tremendously in the last 10 years, but it still only accounts for about 25% of all U.S. supply. And there was a 25% decline in oil rig activity in the U.S. last year, which caps associated gas growth in the next year or two. So we still need gas-directed drilling in the U.S., and we don’t think current prices offer enough incentive for producers.

The other big concern for investors is weak global LNG markets. LNG exports are expected to make up around 10% of domestic demand for natural gas in the next few years, and weaker spreads would normally result in lower export volumes and thus lower demand. But in this case we think utilization of U.S. liquefaction facilities will remain above 90%, as it has been in the last few years despite weakening international prices. That’s because U.S. exporters, like our top pick Cheniere Energy, have locked up a large portion of their capacity with take or pay contracts, which means buyers are required to pay for the gas whether they accept delivery or not. And because they already paid for it, they may as well take it, regardless of what price spreads look like at that point in time.

So that drives up demand for natural gas, and U.S. gas producers must collectively raise their output by at least 12% by 2025 to keep the market balanced. But at current prices only the very best acreage is profitable on a full-cycle basis, which is why the gas rig count collapsed during 2019. That means prices must increase to incentive the drilling activity required to balance supply and demand in the next few years. Higher prices should buoy most gas-focused upstream stocks, but as some of the most attractive names also have weaker financial health, we recommend focusing on the midstream exporters instead. The largest of them, Cheniere, is around 30% below our $78 fair value estimate.