Too Much is Not Enough – Would more storage capacity help the natural gas market, or just make matters worse?

If you follow the gas markets closely, you may have noticed a not so subtle dichotomy. The current and projected natural gas supply-demand balance seems to indicate there is not nearly enough natural gas storage capacity.

[Posted by contributor Amol Wayangankar]

Today, capacity utilization is 45% above the all-time high for early March and it seems to be headed toward a train wreck in the late summer when all storage capacity in North America will be full and natural gas production will hit a wall. This has been documented in earlier RBN blogs including My Capacity Runneth Over. 

But at the same time, the market price signal that indicates the value of natural gas storage – the winter-summer price spread – is at an all-time low on the NYMEX forward curve.  …In the 60 cent range over the next year but then dropping to the 30 cent range in future years…nothing to be excited about if you are a storage developer hoping to pre-sell capacity or for incumbents staring at contract renewals in the near future. Storage customers on the other hand may be hoping to lock-in some long-term capacity deals at attractive market rates to be well positioned for a turnaround in the market.

You might think that a shortage of storage capacity should send a price signal to the markets that more storage needs to be built.  Clearly that is not happening.  How can the perceived lack of storage not be reflected in the forward curve?  That’s because “not enough storage” is not the real issue.

Let’s revisit the math. We stand at 2.6 TCF of inventory today and let’s say we end the withdrawal season with 2.2-2.4 TCF remaining in storage. That seems to be the general consensus. If the injection season matches last year, another 2.4 TCF would be added, increasing the balance to 4.6-4.8 TCF.  That would be bad, considering that the total capacity of U.S. storage is about 4.3 TCF according to EIA.  But it gets worse.  Due to the shale juggernaut, production is running well ahead of last year.  If today’s production levels continue (as of early March 2012), it would imply that natural gas balances theoretically would hit 5.9 TCF – 40% over the max.   If 2012-13 winter withdrawals are the same as 2010-11 (a relatively healthy year), we would take 2.3 TCF out of storage, leaving a whopping 3.6 TCF at the END of the withdrawal season.  These numbers are “over the top” in all senses of the phrase.

Given those astronomical level, one might expect some market signals to reflect this capacity shortfall.  But there is no such signal.  There must be something missing.  And that something is - demand.  Without a substantial increase in demand there is no reason to put gas into storage, because there will be no reason to withdraw the volumes during the winter of 2012-13.  Obviously, participants in the natural gas market only put gas into storage that they plan to withdraw and use during periods of higher demand.  Said another way, …What goes in needs to come out and if it doesn’t it need not go in to start with”.  Consequently the market does not need more storage capacity, and that is exactly the signal being sent by market prices.

To avoid hitting that wall in late summer, sometime relatively soon we need to see a correction in the imbalance of about 6 Bcf/d (~1.3 TCF).   Most likely the producer will need to bear the bulk of the burden (shut-ins, scaling back drilling operations etc.).  Demand is the real wild card here.  If inventories hit the wall resulting in prices below $2.00, it is unclear what kind of demand response we might see. 

In summary, the market does not need more storage.  It needs enough demand to absorb the gas that is put into storage.  Otherwise gas put into new storage facilities would just stay there forever, an economically irrational outcome.

What does this mean for midstream operators, investors and storage developers?  Well things have not changed much since the perfect storm for natural gas storage markets in 2010. Comparing gas storage value drivers from 2008-2011, gas prices fell from the low-teens down to the $4.00 range, spot/prompt volatility reduced by a staggering 50%, seasonal spreads fell below $1.00 and the market responded to these paradigm shifts: Storage capacity lease rates for the high-cycle market fell by 40-50% while reducing by 30-40% for the slow-cycle market, average cycles marketed fell to 3.5 cycles (from 8-10 cycles in the good ole days), ancillary revenue streams (PAL/wheeling) took a hit as well and overall storage project development slowed down considerably with 50% of projects either cancelled or shelved.

Not a pretty picture. And if you thought you saw the bottom of the barrel in 2011, 2012 has been worse…my market intel points towards rates in the range of $0.05-0.07/MMbtu-month for high cycle storage (5+cycles). Not surprisingly, customers have been aggressive in locking in these rates for periods that were unheard off in 2008 (especially for projects west of Henry Hub). Anecdotal evidence points towards firm capacity deals for 10 years at some projects. Of course, existing projects with capabilities of optimizing the merchant capacity on their own books and who are not encumbered by financial covenants are staying away from locking capacity for the long term. Projects are also hunkering down and optimizing capital expenditures on future expansions by building storage space but not increasing deliverability. That may be the norm for the next few years until the gas market comes back to balance.

So to recap, there is NOT ENOUGH storage capacity to accommodate the surplus supply situation, but if the capacity did exist, it would be TOO MUCH capacity – more that the market needs.  The real culprit is demand.  In the short term, we will see wider spreads this year as spot prices get crushed by the storage capacity problem  It will look good for intrinsic value this year, but not for future years.  Volatility-based extrinsic value will be an interesting variable to watch over the next few months.  Depending on how and when natural gas storage hits the wall, it could make for a very unstable market.