Winter Is Coming - Natural Gas Prices Must Rise

Includes: UNG
by: Glenn Doty

For the fans of George R. R. Martin's epic fantasy world, the allusion "winter is coming" has a specific meaning: It's easy to enjoy the good life, but easy living can make you soft, and when hardship comes you're likely to be ill prepared to face it. Martin's world has an uncertain seasonal shift, where summers can last for years, but when winter comes, winter is BAD.

While we don't live in a fantasy world where seasons are uncertain, we in America happened to have faced that very scenario during the period of 2011-2012. Winter didn't come, and now we are enjoying the summer of cheap energy.

In the "winter" months of 2011-2012, temperatures averaged 4 degrees (NYSE:F) warmer than normal across the entire U.S. Most Northern states - ME, NH, VT, CT, MA, RI, NY, PA, VA, OH, WV, KY, IN, IL, MI, WI, MN, IA, MO, ND, SD, and MT all saw temperatures of ~6 degrees warmer than normal, When the cold didn't arrive, we Americans proved to be just as easily lulled by the good life as the people in fantasy lands.

The most obvious sign of long-summer complacency can be found in the natural gas market, and the breathless optimism of the world concerning cheap energy and diminishing coal usage. Recent whispers by heretofore respectable analysts have seriously discussed the possibility of free methane ("profit could be derived solely from extraction of natural gas liquids and higher-value light hydrocarbons")… and seemingly every environmentalist group is giddy about the near-term abolition of coal power plants in a world of perpetually low-cost natural gas, with headlines proclaiming that natural gas sourced electricity matched coal sourced electricity in the month of April!

The EIA is projecting a cost of only ~$2.55/1000 cubic feet [1mcf]) for 2012, and ~$3.22/mcf for 2013 under the apparent logic that recent short-term trends must continue forever.

wellhead price of natural gasClick to enlarge

What everyone seems to overlook is how we got here - to a place where people are discussing free methane. Everyone seems to just be content to bask in the easy life of a long summer and assume that life is good now because it will be.

Fracking: The Beginning

Many people are familiar with the concept of fracking - short for hydraulic fracturing. Fracking involves using high pressure chemicals and salt solutions to wedge open horizontal pathways between subterranean reservoirs. What this has done for the natural gas industry cannot be understated.

Much of the easily accessible huge gas reservoirs that could produce for decades have largely been depleted, and the industry is now forced to either drill in deep water or search for much smaller pockets of gas embedded in shale formations. The advent of fracking means that instead of drilling 2-4 miles into the Earth's crust to siphon off a small pocket of gas, then having to move a few hundred feet and drill another well 2-4 miles into the Earth's crust to get to another small pocket of gas; now they can pump a high-pressure solution into their existing well, set off a few underground explosives, and soon there will be gas produced from their well from a gas pocket a few hundred feet away. That's millions of dollars saved per dry gas pocket that is accessed, and these small gas pockets throughout shale formations are now economically viable.

In Jan 2008, the U.S. was producing ~5 billion cubic feet per day [Bcf/d] from shale formations. By Oct 2009 that number had doubled, then doubled again by May 2011. Gas became cheap again.

The industry had already started to shift its course as wellhead prices dropped from $11/[mcf] to $4/[mcf], but there was great uncertainty concerning regulations on fracking which kept gas companies drilling, out of a sense that they should make as much progress as they could before regulations clamped down.

However, the current administration has made no attempts to restrict fracking, nor seems inclined to do so without real evidence of damage or danger.

Wind Energy, Natural Gas, and Coal

Wind energy has been growing at a pace that far exceeded expectations. The growth in wind energy has had a significant impact on natural gas demand from the electric power industry. While the details are complex, the base relationship is this: Wind energy is variable and uncontrolled. Therefore, in order to balance wind energy, there has to be enough "dispatchable" (natural gas) energy ready to ramp up or tamp down quickly when the wind power changes. This has contributed to a gradual increase in natural gas utilization, which led to a gradual decrease in coal utilization.

This worked out well for the natural gas market. There was a gradual increase in NG demand from the electric power industry even while the price of natural gas held constant, which had accommodated the gradual increase of NG supply that was produced from growth in fracking.

As can be seen in the following two tables, NG and wind have been the only factors that have had a significant impact on the "grid mix" of electricity. Eliminating all other factors yields very little error in determining the reason behind the reduction in the use of coal. The rest of the discussion around this issue is largely just noise.


[TWh] generated by coal

[TWh] generated by NG

[TWh] generated by wind

Total U.S. energy demand































Click to enlarge


Change in coal generation [TWh]

Change in NG generation [TWh]

Change in wind generation [TWh]

Change in total US demand


























5-yr trend





Click to enlarge

Even with NG sourced electric power averaging a 40 [TWh/yr] increase, the NG supply expansion exceeded the rate of growth in natural gas power.

The Missing Season

By November of 2011, with fracking outpacing the growth in demand from the electrical power industry, there was a new record set for the amount of working gas in storage of 3.85 trillion cubic feet [Tcf].

Had the winter period of 2011-2012 then followed as normal, somewhere between 2.2 and 2.5 [Tcf] would have been drawn down through the course of the winter, the price would have largely held, and we might have seen another 30-60 [TWh] of natural gas sourced electrical power for 2012 - and there would be no story.

But winter didn't happen! The residential demand for natural gas was 572 Bcf lower between December and April than the 5 year average for those 5 months, and the commercial demand was 196 Bcf lower.

So the season began with stored gas at a record level, and gas production at a record level and still climbing, and typical heating demand for gas throughout the U.S. fell by 767 billion cubic feet [BCF] (<14%)! Prices began spiraling down to entice more electricity usage, and during the first 4 months of 2012 there was 371 [TWh] generated from natural gas sourced power, 94 [TWh] more than seen during the same four months of 2011, just the first four months saw significantly more growth in natural gas than any previous full year in recorded history.

Natural Gas Deliveries to Electric Power ConsumersClick to enlarge

Even with the shocking increase in NG-sourced electrical power, there was still only a draw-down of 1.5 [Tcf] of working gas in storage for the December-March period. Working gas bottomed out at 2.37 [Tcf], a full 760 [Bcf] higher than the prior year's nadir.

It's difficult to realize the effect that the increased demands of winter have on our day-to-day life in the modern day world. In the past a man would spend several hours a day splitting wood, regardless of how warm it might be. With natural gas, however, a small number of decision makers call for 100 [Bcf/wk] of injections into storage, and the rest of us go on our merry little way - so it's easy to not notice when the rate of injections are cut in half. Then we suddenly wonder in awe at the low price of this gaseous commodity that the industry cannot store and must keep dropping the price in order to sell.

When you find yourself in a hole, stop drilling.

Now, finally, we get to the bad news.

While it's fun to look at the trends and see the reasons that the price of gas is absurdly low, and whisper about "free methane" or exchange high-fives over the drop in monthly coal utilization; the gas industry has no motivation to keep drilling for more gas when they are forced to sell it at an unreasonably low price. The same drilling rigs that are used to punch wells into gas pockets are also used to punch wells into reservoirs of crude oil. If oil is trading at $85/[bbl], and gas has a wellhead price of $2.50/[mcf], then the price of oil is 5.8 times that of natural gas on an energy basis. It does cost more to drill for oil than for gas on an energy basis, but not 5.8 times as much. The natural response, one would assume, is to stop using the drilling rig to drill for gas, and instead use the drilling rig to drill for oil.

That is exactly what is happening.

Number of Drilling Rigs in U.S.Click to enlarge

Traditionally, there has been between 2 and 5 times as many operating natural gas rigs as there have been crude oil rigs in the U.S. When the great recession hit and crashed the value of both gas and crude in 2008-2009, more than half of the rigs in America were taken offline completely, as there simply wasn't sufficient value in the product to warrant continued drilling.

Since the natural gas production per well increased significantly (due to fracking), more of the recommissioned rigs were tasked to drill for crude than gas - because there was more profit in crude oil. But the rigs were still in high demand for both gas and oil. Between August 2010 and October 2011, the number of natural gas rigs dropped from 983 to 933, while the number of oil rigs climbed from 644 to 1,077.

However, once the winter of 2011-2012 did not materialize, these ratios started changing dramatically. Between October 2011 and June 2012, the number of natural gas drilling rigs dropped to 541, a 13-year low, while the number of crude oil rigs increased to 1421, more than twice the highest number seen in America prior to Nov 2010.

Winter Is Coming

The money is in oil now, and that's what everyone is drilling for. But that means that the production of natural gas is dropping. There's a significant lag between drilling rig assignment and adjustment in production. The wells continue to produce for some time, especially fracking wells - which just have to be re-stimulated in order to open up more pathways to more gas pockets. But in all cases the act of fossil fuel extraction involves removing a finite amount of hydrocarbons from a fixed place. The wells will see their production slow and eventually stop.

2012 began with natural gas production exceeding the previous year's production level by 8.39%. At the end of June 2012, gas production was only 3.18% higher than a year before. January 2013 will certainly see lower gas production then was seen at the beginning of this year.

The winter of 2011-2012 was the result of several compounding weather cycles. Yes global warming is happening, yes it is man-made… But the climate models tend to agree that warming will be between 1 and 5 degrees C by the end of the century, not 3 degrees C warmer in a single year. Winter will return, and equally significant weather phenomena could just as easily result in an unusually cold winter. When - not if - winter occurs, natural gas prices must climb quickly or there will be an unacceptably rapid draw-down of stored working gas.

Natural gas production will continue to drop for a year beyond the point when the rig assignments again reverse and the industry begins seeking natural gas again (again production lags rig assignment). The only recourse will then be that electric companies will have to shift away from gas and towards coal in order to again match demand to supply… That will only happen when the price rises again, and so it must.

While I can't match the drama of Martin's world, where winter brings undead zombies to prey on the living… There is an element of horror in our story: especially in the sense that you are watching the plot unfold and there's nothing that can be done to stop it. It's not a conspiracy or an evil plot.

The oil and gas companies are drilling for what gives them greater profit, and current storage issues make drilling for gas offer too low of a return to be worth the investment (in fact, it ruins the return on the investments they have made over the past several years). The fact that they know this is an over-correction, and will result in a restricted gas supply in the future doesn't change the numbers now. No-one wants to be the sucker who's paying to drill for free methane and eliminate the profit of their current producing wells. It's better to spend the same amount to drill for $85/[bbl] oil and wait for winter.

The price of natural gas will quickly revert to ~$5/[MMBTU] if we have a normal winter, and coal utilization will simply rise until price stability is reached. If we have a colder than normal winter, all bets are off, and we might be wishing we could choose the zombies. So you might want to keep an eye out on UNG prices throughout 2013 - they're currently a steal.

A quick note for all:

I've grown tired of the shocking levels of misinformation and misunderstanding about energy matters that have become the norm in our political and social discourse, and so I've decided to write a series of non-partisan discussions on some of the basics of the energy world. The goal is to elevate the discussion at large, as this is far too important to reduce to ignorant partisan sniping. A secondary hope is that we might serve to reduce some of the "shock and loss" effects of investment based on hype and a misunderstanding of the energy world at large.

As this is my first entry in the series, I invite any constructive comments or questions. The questions may be responded to in the comments section or may serve to provide the subject matter for my next entry. If you appreciate the style and content let me know, and spread the word among your friends and among your corner of the blogsphere.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.