Energy Prospectus

Raymond James Energy Stat
July 18, 2022

Energy Stat: A Key Reason We're Still Bullish on U.S. Gas? Constraints on Coal Power Burn Share

The biggest surprise in our U.S. natural gas model so far this year is not either producer capital discipline, or high U.S. LNG exports — it’s the limited switching between gas and coal-fired power generation YTD despite high gas prices (at least if we ignore the Freeport outage last month). At the beginning of the year, we anticipated ~1.5 Bcf/d of “loosening” in the natural gas market in 2022 from coal taking power generation market share (~10-15% of season ending storage). Despite even higher than expected prices, coal has not taken share back from natural gas — totally counter to industry intuition. Today's Stat discusses: 1) the evolving relationship between U.S. prices, inventories, and power burn; 2) various constraints in the U.S. coal/power markets impacting power generation market share; 3) the potential impact on an already stretched U.S. natural gas market; and 4) stocks to consider in the context of the recent selloff in U.S. natural gas prices.

Current inventories are squarely in the range of outcomes the U.S. market has seen dating back to 2014 — only a modest deficit to the 5-year average. Meanwhile, pricing has been materially higher than in periods of similar (or worse) inventory deficits (ex: 2014, 2018, and 2019). One contributing factor: although Henry Hub prices have ranged between $3.50 and $9.50 this year, natural gas has actually held steady at 60-65% of U.S. thermal generation. The structural driver for reduced generation flexibility is coal retirements — ~24 gigawatts of retirements expected by 2024, half coming next year (~5% of the U.S. total). While U.S. coal retirements are a clear narrative driver, an analysis of U.S. coal power generation utilization rates provides fairly convincing evidence that retirements don’t tell the whole story. Roughly half the remaining ~25 Bcf/d equivalent coal generation capacity was not being utilized. Non-fuel costs associated with regional import costs (e.g., freight rail and labor costs) also constrain coal usage and/or economics.

Bottom line: we’re not expecting any increase Y/Y in U.S. natural gas-to-coal switching regardless of high natural gas prices, and switching is likely to remain limited in future years. Finally, our report compounds on the points made in last week’s Energy Stat — we do see overall U.S. natural gas price risk/reward as compelling after the recent sell-off.

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Implications: What does this mean for U.S. natural gas inventories and prices?

All things considered, we still see notable upside in U.S. natural gas prices in 2023. Recall, although inventories build in 2023, U.S. natural gas days of forward cover still only improve to about ~25 days vs. the 5-year average of ~27 days. In other words, we continue to see a relatively tight market in 2023, and we still like our call for higher than strip prices next year (though the Freeport outage remains an uncertainty). No doubt, the price inelasticity demonstrated by natural gas so far this year and the general constraints on coal-fired power generation could both be massive wild cards throughout the year — but the >500 Bcf swing in annual U.S. natural gas power burn market share gains relative to our initial supply/demand forecast in January 2022 is already enough to reset the picture for prices through 2023.

Moreover, we think the risk/reward of natural gas-focused energy companies is fairly attractive right now given the recent and material pullback in U.S. benchmark prices (with only modest fundamental rationale). As we stated yesterday, one could even argue that natural gas focused names actually look more attractive than oily peers considering that the recent oil market sell-off has been less pronounced. My favorite gassers are AR, CTRA, CRK, EQT, RRC and SBOW.

A question we regularly receive is “with the coal/gas relationship broken down, what’s the new ceiling (or inflection point) for U.S. natural gas prices?” With limited coal vs. gas switching visible, backing out U.S. LNG exports would be the ultimate price ceiling for U.S. natural gas (with winter U.S. northeast price history being a case study). However, international prices are so elevated that this is not realistic today. The remaining options are industrial demand (e.g., aided by passing through inflation to customers, as well as lower opex costs vs. international producers) or exports to Mexico (similar to behavior in LNG markets). Our contacts suggest ~$10 Henry Hub prices would still cut ~10-15% of industrial demand out of the market despite the aforementioned U.S. industrial demand tailwinds.

Stocks to play the theme?

E&P: Given natural gas’s recent pullback, several of our E&Ps sit primed to benefit — both via domestic and international gas exposure. In the U.S., our top-rated gas name continues to be Antero Resources (AR). Antero currently has ~1.0 Bcf/ d committed to LNG export facilities (non-material exposure to Freeport LNG), with an additional ~1.3 Bcf/d of firm transport access contracted through (at least) 2030. Additionally, AR trades at just a ~2.9x forward EBITDA multiple (stock down ~40% over last month), while possessing a large-cap leading ~26% 2023 FCF yield (only ~2% hedged on gas in FY23 vs. ~50% in FY22). The company intends to distribute over 50% of FY22 FCF to shareholders via stock buybacks, with total distributions (% of FCF) set to increase into FY23 (likely combination of buybacks + material base dividend).

On the same note, Southwestern Energy (SWN) represents a similar way to play nat gas, given the company’s current LNG commitments (also ~1.0 Bcf/d & minimal exposure to Freeport) and proximity to the Gulf Coast (e.g., the largest Haynesville operator by daily production). Additionally, SWN recently kicked off a $1 billion share repurchase program to be completed by YE23.

Midstream: As stated last week, themes are similar in midstream-land to that of the E&P space, though on a smaller scale. Commodity price exposure in midstream is more heavily weighted to natural gas liquids (or NGLs) rather than natural gas (though there’s usually more natural gas price sensitivity than that of crude oil). Still, fluctuations in U.S. natural gas prices can move the needle: companies with the most natural gas price exposure in the space include larger gathering and processing companies DCP Midstream (DCP) and Targa Resources Corp. (TRGP), as well as The Williams Companies (WMB) — which has both gathering and processing and upstream assets. Each has been hit on the recent sell-off, but is Strong Buy rated for both its exposure to today’s theme, and stock-specific catalysts — so we see this as a compelling entry point for these names.