We have all read about the increase in natural gas production and the expansion of supply created by "fracking" breakthroughs. For a old timer and veteran of the natural gas "curtailment" era, it is a very surprising development. For years, the conventional wisdom was that we were running out of natural gas. As recently as 10 years ago, there was somewhat of a consensus that numerous LNG terminals would have to be built so that we could import massive amounts of natural gas. Now, suddenly, we seem to have a surplus and prices have plummeted. In the old days, an MCF of natural gas was generally priced at one tenth the price of a barrel of West Texas Crude - that metric would yield a price today of about $9 and nobody believes that is on the horizon.
Trends in Natural Gas Production and Consumption. I have tried to understand recent trends by using 2006 as a base year (it was after Katrina) and comparing it with 2011 and 2012. The first Table sets forth the production, imports, exports and electric generation consumption of natural gas over this time period express in Quadrillion BTUs. Both tables below are based upon recent data from the Department of Energy, Energy Information Administration.
|Natural Gas||Production||Imports||Exports||Elec. Gen. Consumption|
The 2012 numbers are estimates based on trended projections of comparisons with 2011. Most of the "trade" is with Canada and Mexico - both of which have substantial natural gas resources - and so the potential to reduce net imports is somewhat limited. It is clear that - of late - the bulk of additional gas production has been making its way into the electric generation utility industry. This is confirmed by an examination of electric utility capacity additions which have included a number of natural gas fired plants this year and suggest that more will be added in the near future.
The Coal Industry. It is also interesting to see how this influx of natural gas is affecting other fuel sources. The Table below provides the annual production of coal in millions of tons as well as the electric utility consumption of coal and coal stockpiles (for 2011 and 2012 - as of July 31).
|Coal||Production||Elec. Gen. Consumption||Stockpile|
Again, the 2012 numbers are estimates based on trended projections of comparisons with 2011. Natural gas is clearly displacing coal as a fuel for electric generation. Production declines have been cushioned somewhat by a stockpile build-up but this cannot go on forever.
Some analysts point out the Winter of 2011-2012 was unusually warm and, because of the heavy use of natural gas as a space heating fuel, this warm winter led to a surplus of natural gas resulting in lower prices and displacement of coal in the electric utility industry. There definitely is some truth to this (I estimate that about 1 Quad of natural gas was saved due to the warmer Winter) but there are also some "secular" trends at work. The data also reveals that 2012 has seen an unusually high level of nuclear plant outages and low production from hydro facilities, and these factors may reverse in future years. The coal industry may, in fact, be looking at a long term decline in consumption from the set of customers which provide nearly 90% of its demand.
What This Means For the Price of Natural Gas. What does all of this mean for investors? First of all, the price of natural gas will tend to be determined by its competition with coal. With electric utilities in the position to switch between coal and natural gas, the prices of the two fuels will tend to be interdependent. This was the case for a long time with respect to natural gas and oil because various industrial users and some utilities could switch back and forth between the two fuels. While the switch between coal and natural gas will not be instantaneous, in the short to intermediate term, there should be enough opportunity for switching to put a "collar" on the price of natural gas. There is simply no place else for the natural gas to go in the short and intermediate term. If the price rises too high in comparison with coal, electric utility consumption of natural gas (which has become a dominant part of demand) will decline and drive down the price. As the price gets lower, electric utility consumption will tend to increase and sop up excess supply. ultimately clearing the market. This price impact is probably the most important investment implication.
Readers should be aware that there will be no mechanical formula for this competitive pricing. Natural gas and coal both carry substantial transportation costs which vary enormously around the country so that, in some locations, low transportation cost coal will beat high transportation cost gas and vice versa. Coal also bears environmental costs in the form of a need for some users to purchase sulfur dioxide emission credits or to undergo the expense of operating a scrubber. Natural gas is increasingly burned in efficient combined cycle plants with lower heat rates than most coal plants, and thus can produce more electricity per BTU. So, you cannot simply compare the per BTU price of mine mouth coal with the per BTU price of well head natural gas. On the other hand, I believe a range will develop within which users will switch depending upon price comparisons as well as these other factors.
The price of petroleum will be largely irrelevant to the price of natural gas. For example, if there is trouble in the Middle East and Oil goes to $150 a barrel, do not hold your breath waiting for natural gas to trade up to $15 an MCF. It won't happen, because the two fuels are not substitutes for one another anymore.
Natural Gas as a Transportation Fuel. By the same token, companies following strategies designed to substitute natural gas for petroleum will be able to rely on relatively low natural gas prices - again, because - if the price goes up, the electric utilities will switch back to coal and lots of natural gas will suddenly be available. Residential and commercial heating customers now using distillate who can switch to natural gas should do so because the price gap is virtually certain to persist for a considerable time. Efforts to introduce natural gas as a transportation fuel will have the benefit of reliably low natural gas prices, and companies like Clean Energy Fuels (CLNE) should benefit. Natural gas in both the United States and Canada will be available at prices very attractive in comparison with petroleum, and Methanex (MEOH) will make out well with its Canadian and United States methanol plants (I hope it builds some more). These industries face a variety of problems, but the risk that natural gas prices will increase or approach the level of oil prices is not one of those problems.
Other Implications. On the downside, alternative fuels and nuclear energy face a tough time competing with the coal/gas axis as these two fuels vie to lower prices to electric utilities. Alternate fuels will increasingly rely upon renewable portfolio requirements at the state level - distributed solar will be viable where there is a combination of high retail electric rates and lots of sunlight. I have said for a long time that Puerto Rico is an almost perfect market for distributed solar.
The coal industry and the parts of the railroad industry which depend heavily on coal shipments may have some tough going. The numbers above suggest a cut back in the most important source of demand for coal and that trend could intensify. Utilities are already decommissioning some of their older coal plants and that trend could also increase. These industry groups should huddle with their lobbyists and support aggressive efforts to introduce natural gas into the transportation sector to divert some of the gas away from the electric sector.
Environmentalists face a dilemma. If they stop or slow down fracking, the near term result is almost inevitably going to be more coal consumption. They have to think long and hard before doing what everyone in the energy industry has always had to do - "choosing one's poison carefully."
The expansion of natural gas production has opened up some important opportunities for the United States. In the long run, it is important that this energy source be harnessed to reduce oil imports by making it a transportation fuel. In the short run, it appears to be destined to expand primarily as an electric generation fuel. This will create some new winners and losers in the energy markets.