On March 24, 2008, Chesapeake Energy (NYSE:CHK) announced a significant new natural gas discovery in the Haynesville Shale, setting off the ‘great shale land grab,’ a period of frantic leasehold acquisitions by natural gas producers. The event also marked the beginning of a profound shift in expectations about natural gas scarcity and natural gas prices.
Over the last three years, natural gas production has grown nearly 14%, which is in sharp contrast to the flat performance of production in the decade before that. Notably, much of that growth has been on the back of pre-Haynesville Shale plays, including the Barnett and Fayetteville shales, among others. Subsequent discoveries, including the Haynesville, Marcellus, and Eagleford shales, are merely adding to the already-rapid pace of growth.
New technologies, including horizontal drilling and hydraulic fracturing, have enabled producers to tap into prolific unconventional resources, which has served to increase the nation’s reserve potential multifold.This newfound ability of producers to increase natural gas production is by now well-established, less understood is the consumption side of gas balances.
With such an abundant source of energy available domestically, many are advocating that the government do more to encourage natural gas consumption. There are obviously conflicting views concerning the government’s role in the functioning of markets. We are less concerned with what the ‘right’ policy is in this instance, and more concerned with the likely course of events and the consequent impact on natural gas consumption.
While gas production has enjoyed a significant uptick over the last few years, the same cannot be said for consumption. Swift growth in electric power demand has been almost exactly offset by steeply falling industrial demand. The other primary components of natural gas consumption, residential and commercial demand, have largely been flat.
At this point, for the sake of completeness, it is worth mentioning another, much smaller component of consumption—vehicle fuel demand. Though much has been made of the potential for natural gas to serve as an alternative transportation fuel to crude oil, the actions of major car makers suggest that they are firmly behind hybrids and electric vehicles in the evolution of automotive technology. There are a mere 110,000 natural gas vehicles in the United States today versus hybrid sales of 130,911 just in the first six months of this year. Currently, natural gas vehicle fuel consumption totals 0.09bcf/d, an inconsequential amount in a 60bcf/d market.
In our view, the most important driver of natural gas consumption going forward will continue to be electric power demand (incidentally, the transition to electric vehicles will benefit natural gas, as it will increase electric power demand). We see natural gas overtaking coal as the primary fuel for electric generation by the end of this decade, which would be an astonishing feat considering current market shares for coal and gas are 45% and 23% respectively.
Coal has already been losing market share over the last fifteen years. In that period, the amount of electricity generated using natural gas has nearly doubled, while the amount using coal (and nuclear) has remained the same. The other beneficiary has been renewable energy, but rapid growth in that segment only began in the last few years, during the relatively high natural gas price environment. We anticipate that concerns over increased regulation, including potential carbon caps, will accelerate the coal to gas transition. Planned generating capacity additions are dominated by natural gas, with many utilities vocal in their intentions to use more natural gas-fired power plants to generate electricity going forward.
While fears of increased regulation will accelerate natural gas market share gains, the recent surge in production has brought prices down to where they can now compete head-to-head with coal on power plant economics. Indeed, last year, especially low natural gas prices led to a 4.2% increase electricity generated by the fuel, despite the fact that overall electricity generated declined 4.0% due to the downturn in the economy. Electricity generated by coal plunged 11.1%, which was a direct result of low natural gas pricing.
Our base case assumes that natural gas demand in the electric power segment grows 6% annually over the next ten years. That is only slightly higher than the rate experienced during the last five, ten, and fifteen year periods, which were 5.4%, 5.3%, and 4.4%, respectively. We see coal demand falling 7% over the next decade, equivalent to losses of 1% annually beginning in 2011.
Even after modeling such an aggressive rate of electric power segment demand growth, we cannot close the gap between natural gas supply and demand. The situation is such that only the lowest-cost producers will be able to grow volumes. While we see value in select E&P’s, the vast majority of the space remains richly valued in an environment of limited growth potential.
Disclosure: Short UNG from $8.70