Capacity Left Behind
Many analysts and traders over the last year have talked about how there is under investment in global oil production. There is little talk however about how there may be under investment in US natural gas storage and that it may be undervalued in the forward market. US natural gas storage capacity hasn’t grown since 2015 while prices, volatility, and both supply and demand for natural gas have risen significantly during this time period. The time spreads that intrinsically value natural gas storage haven’t changed much since 2020, which may indicate that the forward market is undervaluing natural gas storage.US natural gas storage capacity is unchanged since 2015. The main reasons why it has not expanded is that capital expenditures during this period were devoted to growing production, bringing on more pipeline capacity and bringing on more LNG liquefaction trains and terminals. Basically, the market forgot about storage.
More Volatility
While the EIA shows lower 48 working natural gas storage capacity at around 4.7 Tcf, in practice, it is more like 4.0 Tcf. The great majority of US natural gas storage is owned by interstate and intrastate pipeline companies, local distribution companies (LDCs) and independent storage service providers.There are approximately 400 active natural gas storage fields in 30 US states. US natural gas storage is made up of 79% depleted production fields, 10% aquifer fields, and 11% salt dome fields. Depleted production fields and aquifers have much lower flexibility in terms of being able to inject or withdraw. Usually, these fields are on injection mode only or withdrawal mode only for several months in a row, leaving almost no option extrinsic value. These storage fields are basically valued as monthly and or seasonal time spreads. Salt dome fields have by far the most amount of flexibility in terms of the frequency of being able to inject or withdraw. Therefore, salt dome fields have a lot of option extrinsic value, especially if they can inject or withdraw within several days.
Time spreads measure the intrinsic value of natural gas storage. Since natural gas storage is an asset with optionality, it also has extrinsic value in addition to time spread intrinsic value. The best way to value natural gas storage is through a series of time spread options, where both the intrinsic and extrinsic value are measured through the ability to inject or withdraw over certain periods of time within certain specified constraints at the storage facility. Extrinsic value in options is theoretically measured by volatility. Higher volatility means higher valuation and vice versa. Additionally, since natural gas storage is a time spread option, its extrinsic value is also measured by correlation. Lower correlation between the contract months means higher valuation and vice versa. Natural gas volatility over the last 100 days has hit new multi-year highs recently.
Storage is Increasingly Valuable
Higher overall prices for natural gas will also cause storage as a time spread option to increase in value through the so-called shadow delta. Shadow delta is when an option is more valuable when prices are at $8/MMBtu than at $4MMbtu, with volatility and correlation held constant. Natural gas is a call skew market, where the market becomes significantly more volatile as prices move higher and vice versa. Therefore, a multi-year bull market for natural gas and the higher volatility that goes with it, will make natural gas storage more valuable. This is especially the case with salt dome storage, where the extrinsic value is very significant.
US natural gas storage is becoming more valuable due to higher prices, higher volatility that comes with higher prices, and higher shadow delta from a multi-year bull market. However, the time spreads that affect the value of natural gas storage have not gone up since 2020. When looking at the total summation of the time spreads between March to April and October to January, they haven’t changed much since 2020, even though the price of US natural gas has more than doubled since then. This is one factor that indicates that the forward natural gas market may be undervaluing storage.
The Longer Term Trend
What are the fundamental supply and demand factors that indicate that the forward natural gas market is undervaluing storage? One factor that indicates that there is under investment in US natural gas storage is that natural gas storage capacity has not increased since 2015. This would not be an issue if supply and demand were constant since 2015. However, the other indicative factor is that supply and demand for natural gas in the US has increased significantly since 2015 and will continue to increase for the foreseeable future. If both supply and demand are growing, there would be a need at some point for more storage capacity. Otherwise, there will always be the potential for time spreads (e.g., March to April) to increase to unforeseen levels, especially in periods of scarcity. Time spreads (e.g., October to January) can also increase to historical highs during periods of abundance if there is a lack of storage capacity to deal with record high production. Both demand and production have increased significantly without any increase in storage capacity since 2015, creating a dual environment where both bull time spreads (e.g., March to April) and bear time spreads (e.g., October to January) can increase to new all-time highs.
In Summary
US natural gas storage looks to be an under invested and under-valued market because time spreads haven’t changed significantly since 2020, storage capacity is unchanged since 2015, prices and volatility have risen to new multi-year highs, and both supply and demand for natural gas have gone up and will continue to rise significantly (thus increasing the usage of storage).
