As the end of injection season approaches, natural gas storage levels remain well below normal levels. Last week’s injection of 36 Bcf put US natural gas storage 168 Bcf behind the five-year average. At the same time, the remainder of the summer will likely remain hotter than normal, adding to cooling demand. Additionally, early signs from US E&P’s earnings announcements indicate they are remaining committed to restraining from production growth. As such, many traders are already looking towards the end of the 2021-22 winter to highlight the dire state of storage. The so-called ‘widow-maker’ spread, or the spread between March and April Henry Hub contracts, is at its widest this summer since the summer of 2018. Today’s Energy Market Insight will focus on that spread and discuss why cash prices at the end of next winter may actually be stronger than the current Henry Hub strip suggests.
The chart below shows the spread between Henry Hub contracts for March and April since 2018. The spread between these contracts, also called the widow-maker, can be extremely volatile in the winter months, driven primarily by the weather. During cold winters, like that of 2018-19, natural gas storage levels deplete quickly and winter strip pricing rises. However, early spring pricing will generally miss out on most price increases as winter demand fades and prices tumble driving the spread between March and April contracts wider. On the other hand, a warm winter will squeeze the March-April spread to near parity as the call to replenish gas storage is less severe. This is why the trade is referred to as a widow-maker, given the weather-dependent volatility that can lead to extreme trading losses. Even so, it is rare for the spread to widen significantly in the summer months, as many traders are still focused on summer cooling demand and the path to end of season storage. This year is different, as the 2022 March-April spread has doubled since early April. This marks the widest the spread has reached in the summer months since 2018, when expanding LNG demand and a hot summer momentarily outpaced natural gas production growth.
There are many factors that can contribute to a widening March-April spread. For one, as traders focus on near-term contracts, relatively small trades on the March-April contracts could have an outsized impact on the spread. The resulting illiquidity in the summer contracts could then be artificially wider than fundamentals would suggest. That is not the case for the 2022 contracts, which show a higher open interest, or the number of open contracts yet to be settled, than all but one of the last five years. About 100,000 open contracts for both the March and April 2022 contracts is unusual for this time of year, even though open interest on these contracts typically peaks between 300,000-600,000 in the January preceding contract expiration. Therefore, the steep drop in strip pricing from March to April 2022 is likely driven by the expectation that, while this winter will be short supply, next summer fundamentals will have shifted back to being more in balance, driving the spread wider.
While the March-April spread has widened significantly, BTU Analytics expects cash pricing to be stronger in April and through the summer of 2022 than the strip currently suggests. This is partially driven by the interplay between gas and coal-fired power generation. BTU Analytics has previously highlighted the potential for gas-to-coal switching, shown in the chart below left that details the approximate Henry Hub pricing that would likely lead to a switch from gas generation towards coal. However, continuing coal retirements are increasingly making gas generation more price inelastic in the long-term, while stagnating coal supply creates the potential for volatile coal prices this winter. Should coal prices continue to rise, as highlighted in the chart below right, coal generation could similarly be pressured next spring as winter demand dissipates. Thus, making natural gas fired generation harder to displace.
If demand for natural gas remains strong, then the other balancing mechanism needs to come from production. However, US E&Ps are largely staying on the sidelines at $4 gas and $70 crude oil. With both futures prices being in backwardation the incentive to add drilling rigs today for production next year is much lower. Thus, BTU Analytics only expects modest dry gas production growth over the next six months. With demand likely to remain strong in both Power and LNG and production failing to grow materially, next summer’s natural gas prices may need to rise considerably to balance the market and close the spread on the March and April pricing. For more on, BTU Analytics’ forecasts of Henry Hub pricing this winter, request a copy of the Henry Hub Outlook.