US natural gas prices are at record lows–about where they were in 1976, and at the low points in the 1990s, in today’s dollars (Figure 1).
There are several reasons why US natural gas prices are so low:
- Our pricing system is based on short-term supply and demand, and storage facilities are limited. It is very easy for supply to overwhelm the system, and prices to drop very low in response, if there is a mismatch.
- US demand for natural gas has been fairly flat for the last 10 years, regardless of price. Of the four major uses for natural gas ((1)residential heating, hot water, and cooking; (2)commercial heating, hot water, and cooking; (3) industrial demand; and (4) electricity), only electrical use has been growing.
- Supply does not drop very quickly, even if prices fall, because producers need to continue to extract natural gas in order to repay loans and to comply with use-it-or-lose-it lease terms.
Besides variability, there are a number of other problems with depending on short-term supply and demand for pricing:
- Today’s prices appear to be far below the cost of production for some providers, leading to the likelihood of a shakeout.
- Unless price levels are higher and more stable, it is not clear that natural gas supply will grow over the next 10 or 20 years, making long-term investment in new uses (for example, vehicular use, gas-to-liquids, and pipelines to underserved areas) questionable.
- Natural gas prices in the US are much lower than prices elsewhere in the world (Figure 2, below). This means that there is likely to be strong demand for US exports of natural gas, most likely as Liquefied Natural Gas (LNG), competing with internal US uses.
Ramping up natural gas production is now very much of interest, even if new sources of demand are not available, because
- Oil prices are high and some believe that natural gas can act as a substitute, and
- Natural gas seems to produce less CO2 than coal or oil.
It is not clear that the current natural gas pricing approach is up to handling this mismatch between supply and demand. In many ways, natural gas is a drill-it-as-you-need-it product, and our current market free-for-all does not recognize this.
Perhaps we should be considering a different method of regulating natural gas, since in many ways natural gas is essential. It is needed for balancing wind and solar PV, and for allowing us to continue to continue to heat our homes and businesses with natural gas. In the early days of gas, gas was regulated to produce a reasonable rate of return for providers. Perhaps something closer to this approach needs to be used again today.
If price is regulated, the amount to be drilled would need to be regulated as well, probably on a month-to-month basis. Higher prices would probably be needed under the new system to provide funds for more storage and for maintenance of pipelines, and to assure that US needs could compete with demand for LNG from overseas markets. I am doubtful that such a method of regulation would be feasible or would be politically acceptable, however.
In this post, I will explain these issues further.
Why natural gas prices are so low?
I see four reasons why natural gas prices are so low:
1. Storage is too full. Our immediate problem now is that storage facilities are too full for this time of year, leaving little space for additional natural gas supply to be added during summer months. This year’s warm winter contributed to this over-supply of natural gas because the winter’s draw-down from storage was lower than expected.
2. Little growth in historical uses. One of the underlying reasons why there is a mismatch between supply and demand is the fact that since 1997, US natural gas consumption has remained close to flat, regardless of price (Figure 4, below). With very low prices in 2011, consumption rose by 2.2% in 2011 compared to 2010.
Natural gas prices recently have been low enough to compete with coal prices. Even at these low price levels, there has been little increase in industrial demand, and no effect on residential and commercial usage (for heating of buildings, hot water, and cooking).
Industrial demand used to be the largest source of natural gas use, but this has been trending downward. Part of this downward trend is likely related to industries moving overseas for reasons related to wages. (Part may be related to spiking natural gas prices, as well.) Residential and commercial use has not been growing because furnaces have been becoming more efficient, and because more attention is being paid to insulation and other conservation measures.
3. Supply doesn’t drop quickly. Natural gas supply (Figure 5, above) does not drop very quickly when prices drop too low because long lead times and large investment is needed to bring supply on-line. Natural gas producers have debt to service and are often faced with “use it or lose it” leases, so are hesitant to stop, for fear of not being able to make use of their investment. A decline in price may be hedged, so the producer does not feel the effect as quickly as otherwise, and take appropriate action.
Profitability of individual wells is based on estimates of long-term future production and future costs–things which are not at all certain. Some small producers may not even be aware of how unprofitable current prices really are.
There is also the issue of large oil and gas companies having difficulty “replacing their oil reserves,” and needing natural gas reserves to substitute for oil reserves. These large oil companies are willing to buy natural gas companies, even if the cost would seem to be far too high, given recent prices. These willing buyers allow production to keep expanding, creating a greater over-supply situation before a shake-out occurs.
It might be noted that supply (Figure 5) is actually not rising very quickly, but given the slow rise in demand (2.2% in 2011), it is overwhelming the system. In 2011, US production of dry natural gas increased by 7.8% over 2010, but this increase is partly offset by an offset by a decrease in imports. When net imports are included, US dry gas supply for 2011 is up by 3.9% over 2010. The low growth in natural gas demand in 2011, plus the warm winter extending into 2012, has been enough to produce very low natural gas prices.
4. New demand doesn’t ramp up quickly. It takes time to find investors for new uses for natural gas. As I will discuss in later sections, there also needs to be reasonable assurance that natural gas will be available for a fairly long period at an acceptable price level, before investors are willing to invest. With our current pricing system, I am not certain that these criteria are met.
Natural Gas Supply Depends on a Sufficiently High Long-Term Price
There has been a lot of discussion about how much shale gas supply will be available in the new few decades. What people seem to lose sight of is the fact that the amount that will be available depends on price. If the US can maintain a high price for natural gas (say, above $10 per thousand cubic feet (mcf)), then a fairly large amount of natural gas may be available. But if price remains in the low $2 mcf range, or is highly variable, a drop in natural gas supply seems likely, probably in the next year or two. Companies will either not want to invest, or will invest for export to foreign markets, where prices can be relied on. Drilling rigs are already being repurposed for oil production, rather than natural gas production.
Aubrey McClendon of Chesapeake Energy, a major shale gas producer, talks about trying to pull back as quickly as possible from unprofitable production, at current prices. Arthur Berman estimates that shale gas producers who are not able to subsidize natural gas production with profits from “liquids” need a price of $5 to $9 mcf to earn a minimum level of profitability.
Gas producers have natural gas reserves on their books, but these too, depend on the available price for natural gas. If the prices is too low, these resources may never be developed (especially if the gas is a stand-alone product, not produced with “liquids”).
Building New Sources of Demand Depends on Having a Stable Long Term Supply
There are several new sources of demand that could be added, such as natural gas vehicles, or gas-to-liquid plants, or pipelines to underserved parts of the country that now use oil for heating. Large investment of these types don’t make sense unless there is a reasonable likelihood that increased natural gas supply will be available for 20 or more years, and as we just noted, such a supply is not likely to be available unless natural gas prices rise and remain high.1 While there have been technology improvements, there is little evidence that they bring the cost of production down to today’s low prices for shale gas producers that do not have high “liquids” content in the mix they extract.
Of course, the flip side of the need for higher price for production is that demand for the new products will be lower with a high natural gas price. This is true both for new products, and existing uses, like electricity. The recent rise in the use of natural gas for electricity occurred in part because natural gas became competitive with coal pricing. If natural gas prices rise, electrical demand for natural gas is likely to stop rising, and may even fall.
Need for a Different Pricing/Supply Mechanism
Both producers and consumers have gotten the message that we have an energy problem, without a good understanding of what that energy problem is. Suppliers are working hard to ramp up natural gas supply. At the same time consumers and industrial users are trying to conserve.
Vaclav Smil in Energy Transitions: History, Requirements, Prospects talks about transitions from one fuel to another taking 30 to 50 years. We are trying to rush the process with natural gas and renewables, producing a partial transition in only a few years. It is hard to move a system at faster than its normal speed. Even a small mis-step with natural gas can lead to very low prices, and no place to put the new supply.
Besides temporary over-supply, temporary shortages can also be expected to become more common, if we try to rush the transition, and do not add adequate new storage. Natural gas is a system that has a lot of month to month variability in demand, because it is used for heating and cooling. If the weather is unusually warm or cold, it is quite easy for the current system to run into outages. For example, Russia could not deliver enough natural gas for heating in Europe this winter; Texas had natural gas outages in cold weather in 2011. I wonder whether new natural gas vehicles will be added, and we will find that there are gaps in fuel for these vehicles, in some parts of the country, when the weather is unusually hot or cold.
I am not sure if any system of determining prices and supply will work very well, given the stresses we are placing on the system. The current system of determining prices on a short-term supply and demand basis produces a lot of fluctuations, and as I have shown, does not regulate the system well. I am raising the question of whether another system might work better because the stresses on the system would appear to be likely to get worse, not better, in the years ahead.
One possibility would be to go to more of a regulated natural gas system, where the amount drilled each month is set by a central authority, and prices are set based on a fair rate of return. I don’t know whether this is even feasible at this late stage, with ownership of different parts of the system so disaggregated, and cost levels varying greatly for different types of providers.
I suppose hidden in the back of my mind is a fear that the natural gas system (like the oil system) will start behaving so badly in terms of pricing and demand allocation that the government will decide to intervene. President Obama’s new Executive Order with respect to Natural Defense Resource Preparedness gives the Energy Department broad powers if problems arise that are deemed to create a national emergency. These powers would seem to include determining who gets what in terms of supply.
Trying to transition quickly from one energy system to another is untrod ground. I am not sure I have a good pricing solution. Perhaps someone else does.
(1) Having high natural gas prices is helpful in assuring long term natural gas production, but such prices are still not a guarantee of long-term production. There are many interactions with the rest of the system. For example, if there are high oil prices and high food prices, there may be civil unrest which disturbs natural gas production. Or imported parts, necessary for further drilling may not be available. Or there may be general financial problems, that prevent getting loans needed for further production. Or it may turn out that shale gas wells do not continue to produce as much gas as hoped, for as long as hoped, and the wells are no longer profitable, even at the higher prices.