Energy Prospectus

Read carefully. This is part of the "Structural Change" that should keep ngas prices high in 2023 and 2024.

From Raymond James

Surprising 2022 coal vs. gas trends have not abated – and likely won’t next year either. Although U.S. natural gas prices have retreated from the highs of the last few months, today’s prices are still well above average compared to the last ~10 years. This caught many investors and analysts “flat-footed” because the U.S. natural gas inventory picture is not materially different from year’s past. In the image below left, we show that there’s typically a moderate relationship between inventory variances and prices. The image also illustrates that 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 five-year average. Meanwhile, pricing has been materially higher than in periods of similar (or worse) inventory deficits in 2014, 2018, and 2019. We believe one major contributing factor is less sensitivity between natural gas burned at power plants and prices within the U.S. marketplace.

We believe “price inelasticity of demand” has increased for natural gas within the U.S. power sector. As we’ve noted of late, 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 is the limited switching between gas and coal-fired power generation YTD despite high gas prices. At the beginning of the year, we anticipated ~1.5 Bcf/d of “loosening” in the natural gas market in “gas year” 2022 from coal taking power generation market share, or about 550 Bcf or 10-15% of season ending storage. That forecast assumed U.S. natural gas prices maintained the ~$4/MMbtu level after the 4Q21 spike, but prices have averaged closer to $6.00 since then (even peaking at >$9). Despite those higher prices, coal has not taken share back from natural gas — totally counter to industry intuition. As shown in the image below right, 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. One can see how this outcome clearly contrasts with the historical downward slope to the relationship in a normal environment usually higher natural gas prices lead to lower natural gas consumption.

If you’re only focused on traditional oil & gas markets, you may be surprised to know that U.S. coal prices have actually kept up with those of U.S. natural gas. Despite higher U.S. natural gas prices in 2022 vs. 2021, U.S. natural gas supplies are a very cost competitive feedstock relative to coal supplies on a fully adjusted basis. Coal is actually quite cost competitive with natural gas on a heat content basis (i.e., $/MMBtu); however, coal-fired plants generally suffer from reduced efficiency when compared to their natural gas counterparts. We decided to compare using the EIA conversion rates of ~0.9 kWh/lb for coal and ~0.14 kWh/cf for natural gas, showing a clear advantage for natural gas. However, remember that heat rate variances suggest roughly a ~1.4:1 relationship for gas/coal break-even pricing (e.g., ~$10 gas = >$7 coal). This means, on a fully adjusted ($/kWh) basis, U.S. coal was actually ~25-30% cheaper than natural gas on average in 2021, yet perhaps only ~15% cheaper in 2022. In other words, U.S. natural gas is actually more economically competitive vs. coal in 2022 despite much higher natural gas prices. While there are several factors to consider, we believe this is likely the largest reason why U.S. coal-fired power generation has been slow to take market share from natural gas.

Why are coal prices elevated? U.S. coal inventories were ~30% lower to start 2022 after strong demand in 2021 (when coal actually took market share). Since then, there’s been no recovery in inventories into winter 2022-23. Further, we don’t anticipate coal inventories ending next year materially higher than even those 2021 levels. Additional factors such as coal retirements and rail logistics constraints are also playing a role in limited switching, but supply/demand tightness and elevated prices are the bulk of the story, in our view. All in, 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.

The 2nd "Structural Change" is the significant increase in US LNG exports.

Raymond James:

U.S. LNG exports are still running pretty hard – all eyes on Freeport ramp, just as domestic demand should jump on winter weather. Other than the Freeport outage earlier this year, U.S. LNG exports have been a major positive for North American natural gas prices this year. Massive international natural gas prices (shown in the below left image at the top of the next page) have reshaped global LNG flows and pushed the U.S. to maximize cargo production. Incremental LNG exports have been one of the leading factors for the bullish current U.S. natural gas market environment as maintenance is deferred and exports are maximized. There have even been reasons for renewed optimism as of late. Last week U.S. LNG feedgas demand was essentially maxed out for stretches last week and achieved its highest levels since the early June shutdown of the Freeport export facility (depicted in the below right image). The commissioning of the Calcasieu Pass export facility throughout 2022 has been a tailwind for natural gas demand, partially offsetting lost cargoes from Freeport.

LNG wildcards: maintenance/restarts, winter weather...and, most near-term, hurricanes. Both our model and EIA forecasts predict a modest increase in U.S. LNG exports in 4Q22, though there are several gating factors. While Tropical Storm Ian doesn’t appear headed towards LNG export facilities we will be watching to hear how it may disrupt shipping lines. This should be a short-term event. Other factors to watch include planned maintenance at Cove Point and the timing and pace of resumption of operations at Freeport in November 2022. We will also continue to monitor the situation between the EPA and Cheniere, but expect no material liquefaction interruption currently. All in, we model an above-EIA 1.5 Bcf/d of growth this year and another 1.5 Bcf/d of growth in 2023. The EIA remains somewhat conservative on U.S. LNG exports in 2022 due to high international prices and global macroeconomic fears. We continue to model higher U.S. LNG exports than the EIA, as the trend for around two years has been for market actuals to easily beat the EIA forecast and typically exceed even our forecast as well.

Raymond James:

Conclusion: despite high prices today and the uncertainty of winter weather, we still like the risk/reward for U.S. natural gas (and natural gas stocks) for the next 12-18 months. 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 ~28 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.

True, there are several wildcards at play today: 1) macroeconomic factors such as the strengthening U.S. dollar; 2) the volatility of winter weather; 3) near-term hurricane impacts; and 4) the Freeport outage and expected ramp. Within current fundamentals, the price inelasticity demonstrated by natural gas so far this year – and the general constraints on coal-fired power generation – could both be massive variables as well. That being said, 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.

While there’s admittedly a lot of downside focus today, 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 ngas 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.
> Beyond that, most investors seem to think a “policy response” to slow U.S. LNG exports would happen in the $20 range.

Top Picks
E&P: On the E&P front, Strong-Buy rated Antero Resources (AR) remains the best way to play our bullish natural gas outlook. AR sports minimal hedges in FY23 (just ~2% of total nat gas volumes), offering investors peer-leading exposure to strip. Having kicked off an aggressive stock buyback program earlier this year (~50% of FY22 FCF dedicated towards repurchases), we expect AR to materially increase this number in FY23 (~14% of outstanding shares), possibly adding a sizable (2%-4%) base dividend as well. In terms of comps, AR screens tops amongst RJ large caps on a forward FCF yield basis (~26%). Additionally, AR’s substantial LNG firm access capacity (~2.3 Bcf/d; only 1.0 Bcf/d committed) further separates the firm from peers.
On the minerals side, Strong-Buy rated Black Stone Minerals (BSM) provides investors exposure to several gassy resource plays. Nearly 75% of BSM’s production is gas, with FY23 hedges encompassing just ~25% of total gas production (down from ~60% in FY22). All-in, we’re forecasting a FY23 distribution yield of ~13%, highest amongst our minerals names.

Midstream: 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 such as Targa Resources Corp. (TRGP), as well as G&P companies with additional upstream exposure akin to The Williams Companies (WMB). Williams and Targa are both down around 15% in the past month despite little impact to their core businesses, and, in our view, a positive risk/reward as it relates to “icing on the cake” commodity price upside within the business into and through 2023 relative to the strip. Each is Strong Buy rated for both its exposure to today’s theme and other stock-specific catalysts, and we see this as a compelling entry point.
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My Top Picks for natural gas are AR, CRK, CTRA, EQT, RRC, SBOW and OKE

I don't see coal to gas switching in 2023 - US thermal coal producers are, where they are not tied to US utility supply contracts, sending every ton possible to Europe (albeit constrained by rail inefficiencies etc). Prices for coal in europe remain elevated ( https://www.theice.com/products/243/API ... 592&span=3 ). Met coal producers are also selling Met coal to European thermal users at crazy rates. Long ARCH, CEIX and METC.