U.S. natural gas prices have surged to multiyear highs which will conserve scarce stocks, encourage more gas-focused drilling and promote a temporary switch back towards coal-fired generation this summer.

Front-month futures prices for gas delivered at Henry Hub climbed to over $3.95 per MMBtu on July 21, the highest since late 2018 and before that late 2014, up from just $1.68 a year ago.

In contrast to crude oil, gas futures typically trade in contango, with nearby contracts trading at a discount to later-dated ones, driven by the greater technical challenges and cost of storing a gas rather than a liquid.

But the six-month calendar spread has narrowed to just a 9 cent contango, in the 76th percentile, compared with a contango of $1.11 a year ago, in the 2nd percentile for all trading days since 2010.

The epidemic depressed gas consumption in the second and third quarters of 2020 and led to a large build-up of inventories.

Late last year, working stocks in underground storage had risen to almost 4,000 billion cubic meters, according to data from the U.S. Energy Information Administration.

But ultra-low prices depressed drilling and production through the second half of 2020 and into 2021, curbing the stock build and holding inventories just below the previous record.

Then the blast of cold weather that hit Texas in February accelerated the rebalancing process by boosting consumption and more importantly leading to a large loss of production as wells froze off.

By April, stocks had fallen below the five-year average, since when prices and spreads have climbed sharply higher to conserve the remaining inventories.

Rebalancing has been helped by close to average temperatures the most populous areas of the United States since June, notwithstanding the heatwave in the Northwest, limiting overall electricity use from air-conditioning.

Protecting Stocks

In the short term, higher gas prices will encourage power generators to run gas-fired turbines for fewer hours over the next few months, running coal-fired units instead, to reduce gas combustion.

In the medium term, higher prices should encourage a faster rise in gas-directed drilling and production, which will filter through in the first half of 2022.

So far, rig counts and output have barely recovered from last year's slump. The number of gas rigs has risen by just 36 or 53% from its cyclical low in July 2020, compared with an increase of 199 or 110% in oil-directed rigs.

As a result, gas production in the three months between February and April was unchanged from the same period two years earlier, after growing rapidly at an average rate of 4.6% per year between 2010 and 2018.

If higher prices are sustained, however, there is scope for the rig count and output to increase significantly. The last time prices were at current levels, in late 2018, the number of active rigs was almost double, at nearly 200.

Since then, the industry has consolidated and many of the larger producers are focused on returning money to shareholders and strengthening balance sheets, rather than growing production.

Nonetheless, prices are sending a strong signal about the need for higher output, with a return to significant production growth likely over the next 12 months.

John Kemp is a Reuters market analyst. The views expressed are his own.

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