After a pathetic 2015-2016 winter in major natural gas demand regions, the fact that Q1 and Q2 2016 will see continued weak natural gas prices is a foregone conclusion at this point.  However there is emerging evidence about the prospect of the market re-balancing driven by lower levels of producer activity and growing demand moving the market to a new equilibrium in 2017 at higher prices from current levels.  In order to reach that new equilibrium the market is likely to go through several bouts of supply-demand dislocation.  The question is when will these supply-demand dislocations occur and what it will mean to the relationship between Henry Hub cash and prompt futures.

The difference between Henry Hub prompt futures and cash (prompt less cash) is a good indication of short-term supply-demand balances.  Obviously when the spread is positive (prompt greater than cash) the gas market is “long” and the incentive exists to buy lower cost cash gas and store it for the future.  Likewise, when the spread is negative (cash is greater than prompt), the gas market is short and the incentive exists to bring all physical gas into the cash market.  If we use the February 2014 Polar Vortex as an example, we can see cash traded much higher than NYMEX futures prompt (as well as any other contract in the futures curve) incenting all production and storage to come into the daily cash market to meet spiking demand.

Looking at a time series of Henry Hub cash compared to the spread (prompt less cash), we see the spread has become less volatile since shale gas and pipeline expansions proliferated starting in 2009.  The Polar Vortex in 2014 is the exception in this case.  The question remains, could natural gas demand growth and reduced producer activity drive volatility back into the prompt-cash spread in 2017?

In order to look at frequency and seasonality of spread blow outs, the top 10 average monthly spreads (positive in green and negative in red) since 1994 are highlighted below against a NYMEX HH prompt continuation.  We see a trend in frequency of greatest negative spreads typically occuring during winter demand spikes in January, February and March.  This makes sense as extreme winter demand spikes signal the market to bring all physical gas to serve strong demand (see red corresponding dots in Jan 1997, Jan 2001, Feb 2003, Feb 2007, Jan 2009, Jan 2010 and Feb/Mar 2014 below).  Meanwhile, the greatest positive spreads typically occur in the fall at the end of the injection season.  Logically, as storage fills and shoulder season demand lags, cash prices become weak while prompt is higher driven by the prospect of coming winter pricing dynamics (see corresponding green dots in Oct/Nov 2004, Oct/Nov 2006, Oct/Nov 2007 and Sep/Oct/Nov 2009 below).

So what does this all mean going forward?  If we look at Henry Hub cash and the cash-prompt spread since January 2012, the spread has averaged negative one cent with a maximum of 50 cents in late 2015 and minimum of ($3.57) during the Polar Vortex in 2014.

In the next 18 months it is likely we will see the prompt-cash spread pushed wider than seen in 2015.  The natural gas storage surplus is currently 843 Bcf to the 5-year average which will likely result in cash weakness this fall (barring huge power burn this summer).  The combination of a normal winter in winter 2016-2017 with excessive cuts in producer activity (dry and associated production) could then create a situation next winter where localized physical shortages could drive cash to spike meanwhile futures pricing will likely remain muted by aggressive E&P hedging programs.  This could drive wider prompt-cash spreads in 2017.  Time will tell. To follow developments in the natural gas market request a copy of BTU Analytics’ Northeast Gas Quarterly.