Natural Gas: Price and Prejudice

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Includes: GAZ, UNG
by: Evariste Lefeuvre

Structural Break

Natural gas has historically hovered in a price range defined by oil prices. The reason historically comes from the fact that part of natural gas production is a byproduct of oil extraction (found in same wells). In addition, industry and power generation have long been able to switch back and forth between natural gas and residual fuel oil. The conventional and expected market price bracket of natural gas prices used to be thought as the following:

Upper band: The heat content (million BTU per barrel) of distillate fuel oil is 5.825. Hence, the upper limit for natural gas price should be a sixth of the current price of a barrel of oil.

Lower band: based on past observation, natural gas prices should mean revert around a ratio of 10:1.


There seems to have been a structural break here as the chart above shows. Since the outburst of the crisis, nat gas prices are pegged well below the lower band.

Power generators able to switch easily from nat gas to residual fuel have dwindled in numbers. This may explain the reason for a new equilibrium between oil and nat gas.

Finding the Missing Link

Even though the nat gas market is competitive and well integrated nationally it remains mostly local in comparison to oil prices. The recent widening of the WTI/Brent spread has highlighted the extent to which U.S. oil prices may depend on domestic supply conditions (overload at Cushing, OK). But oil prices remain strongly affected by international factors such as global demand, OPEC policy, and geopolitical risk.

Supply Side: The Shale “Revolution”

Reserves have also played an important role recently due to the shale gas “revolution." This new source of gas has benefited from extracting innovation (horizontal drilling/hydraulic fracturing) that lower production costs. It represents only 15% of U.S. supply (approx 9 bcf/d out of a total U.S. production of 58.5 bcf/d) but accounts for most of the marginal increase in dry gas production.

In addition, according to the Potential Gas Committee, the United States possesses a total resource base of 1,898 trillion cubic feet (Tcf) as of year-end 2010. This is the highest resource evaluation in the Committee’s 46-year history, exceeding the previous record-high assessment by 61 Tcf. Most of the increase arose from reevaluation of shale-gas plays in the Gulf Coast, Mid-Continent and Rocky Mountain area. According to EIA, U.S. total nat gas reserves are estimated at 2550 Tcf (more than one century of supply) from which Shale gases account for 830 Tcf (Marcellus, Haynesville, Barnett and Fayetteville basins account for 600 Tcf). The U.S. economy is becoming self sufficient in terms of nat gas supply. Yet, one should always keep in mind that potential/technically recoverable resources are not the equivalent of proved reserves.

This leaves the U.S. economy with a huge amount of supply for the foreseeable future and a genuine cap on prices if demand fails to catch up (primary energy substitution takes time as oil to coal substitution showed in the 19th and 20th century).

There might be some over optimism on the supply potential. Regulatory requirements could emerge shortly (burning natural gas is environmental friendly but the extraction of shale gas not really: land access may be constrained; water access/use and contamination is a key issue; health impacts are unknown). The rapid depletion of newly discovered fields could also be a cause for concern.

From Oil to Coal: Power Generation and Coal-to-Gas Switching

The demand potential for natural gas is high: Residential heating, car/truck conversion. Yet, without coal-to-gas switching, natural gas prices would be much lower today. The over supply of natural gas has enabled a sharp reduction of imports, but in the absence of LNG exports facilities, part of the excess supply has been dedicated to power generation ... at the expense of coal.

According to EIA data, from 2000 to 2009, the share from coal in power generation fell 7.2% from 51.7% to 44.5% while that of natural gas rose 7.5% from 15.8 to 23.3%.

As in the case of natural gas, coal reserves are huge (several hundred years) but mostly on the form of bituminous (Appalachian) that not only have a low energy content but also emits SO2 (acid rains, respiratory issues, etc.).

Environmental considerations/regulation are having a long run impact. Natural gas prices may find some medium run respite from the coal-to-gas switching in power generation as there are much more utilities able to switch from coal to nat gas than from oil to nat gas.

Even though coal plants are the most powerful (in terms of MW), they are old (40% were built more than 40 years ago) and capital intensive. Nat gas power plants are less capital intensive, less powerful but more flexible as gas turbines are more easily switched on/off than steam turbines.

The relative volatility of natural gas and coal prices can be explained by the fact that coal has a single use (electricity vs. residential and commercial heating, industrial use for natural gas), is easily storable (natural gas capacity is and costly) and serves a stable load of power generation (nat gas, not coal, will be used at the margin for electricity peaks).

Drill

The wide spread between oil and nat gas prices has diverted resources away from natural gas to oil in terms of drilling. Even though oil production peaked in the U.S. in the early 1970 (oil production stands at 5.5 mbd), rig count data suggests that investors have been favoring oil drilling projects recently.

The price arbitrage is obvious here: The relative price of natural gas to oil has triggered a change in the allocation of drilling equipments (see chart below).

Conclusion

Barring short-run issues of weather and injection/inventories seasonality, natural gas prices should register a structural change in medium run pricing.

On the supply side, the shale gas revolution is supposed to cap any upward pressure on natural gas prices. Production remains at an all time high in spite of low prices and non-conventional reserves have once again been revised on the upside.

Supply may be constrained by regulation, rapid depletion and a possible downward revision of reserves. Whatsoever, the trend is here and at the current level of demand, supply should limit any upward pressure on natural gas.

On the demand side, the new energy mix associated to coal-to-gas switching will spur the demand upward for the decades to come. Nat gas plants are more flexible, less capital intensive and more environment rules compliant as much less CO2 is released. This move could be accentuated by the old age of many coal plants.

In addition, exports may increase somewhat given the sharp increase of LNG imports of many advanced countries (Japan, U.K.), even though in 2010 the U.S. remained a net importer (4% of world imports).

It will take time for natural gas prices to come back to their pre-crisis levels. Yet, the idea of long term cheap nat gas should be reconsidered given the long run trend depicted for supply and demand.

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