Taxed gas market could remain volatile through 2025

Kathleen Davis, Associate Editor

From executive to end-user, most people think “high prices” when they hear “natural gas crisis,” and it’s true that high prices—from wellhead to monthly bill—are the most visible aspect of this situation.

According to a Merrill Lynch report, natural gas prices “are likely to remain high, although with greater volatility” through 2004. In fact, their team projected a $4.75 Henry Hub forecast average. (Fitch Ratings 2004 outlook agreed that volatility will continue to be an issue, as did GF Energy’s “2004 Electricity Outlook,” where respondents labeled natural gas prices as one of the “three biggest increases expected in the next year.”)

“Natural gas prices have become higher and more volatile during the past three years, to the detriment of all gas consumers,” wrote David Parker, president and CEO of the American Gas Assn. (AGA) in the forward to “Avoiding the Wild Ride: Ways to Tame Natural Gas Price Volatility.”

Questions remain: Just how long will this imbalance last, and are there steps we can (and should) take to fix the problem?

“AGA is convinced there are sufficient supplies of natural gas domestically and throughout the world to satisfy growing demand for generations to come. However, until we as a nation unlock the resources at our fingertips, a tight market conducive to price volatility will persist,” Parker added.

The future: Stardate 2025

Gas consumption is expected to continue to rise until 2025, according to the Energy Information Administration’s “Annual Energy Outlook 2004” (AEO2004). In fact, according to AEO2004, the projections for domestic natural gas consumption in 2025 range from 29.1 trillion cubic feet (Tcf) per year in the low economic growth case to 34.2 Tcf in the rapid technology case, as compared with 22.6 Tcf in 2002.

The AEO2004 projects that prices for natural gas delivered to the end-use sectors are expected to fall early in the forecast, due to a decline in wellhead prices. However, continuing the “boom and bust” cycle typical of the natural gas industry, the upswing will be back into play between 2006 and 2012, although AEO2004 suggests that this increase in wellhead prices might be offset by a decline in transmission and distribution margins.

Overall, the report sees end-use prices jumping by 54 cents per thousand cubic feet (Mcf) between 2006 and 2025 (in constant 2002 dollars). Additionally, the AEO2004 forecasts an increase of approximately 97 cents per Mcf in the average price of domestic and imported natural gas supplies.

According to the report, “the slower increase in delivered prices reflects continued depreciation of existing infastructure, increased pipeline utilization, and more imports of LNG directly to end-use markets.”

Additionally, AEO-2004’s reference case scenario projects a growth in “unconventional” gas production (tight sands, shale, coalbed methane) in the lower-48 from 5.9 Tcf in 2002 to 9.2 trillion cubic feet in 2025. AEO2004 predicts a slight decline in conventional gas production from 10 Tcf (2002 numbers) to 9.5 Tcf by 2025, “as resource depletion causes exploration and production costs to increase.”

“Since the beginning of 2003, the circumstances in which our industry finds itself have become plainly evident through significantly higher natural gas prices,” Charles Fritts, vice president of government relations for AGA told the Senate’s energy and natural resources committee in a written statement in March of this year. “Natural gas prices have consistently hovered in the range of $5-6 per thousand cubic feet in most wellhead markets.

“In some areas where pipeline transportation constraints exist, prices have skyrocketed for short periods of time to $70 per Mcf. Future prices for natural gas as far out as 2007 continue to reflect a wellhead price expectation of greater than $5, as they have done for more than a year,” he said.

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Merrill Lynch analysts reported in their “2004—The Year Ahead”: “The upward shift in natural gas prices and attendant increase in volatility will have diverse consequences for various segments of the gas industry. Obviously, producers benefit from higher prices, although utilities with production likely hedged away most of their 2004 market exposure last year. At the other end of the pipe, gas utilities can be hurt by industrial and/or commercial demand destruction and increased bad debt expense. High gas prices also make it difficult to seek recovery of other rising costs such as pension and insurance expense as regulators focus on the customer’s bottom line.”

General recommendations

In “Avoiding the Wild Ride,” AGA suggests the following remedies for the current state of the natural gas industry:

“- promote additions to the gas infrastructure;
“- encourage dual-free capability for large volume energy users;
“- promote storage options;
“- loosen legislative restrictions.

AGA has stated that it feels volatility is not just a supply issue (meaning we need more wells and more drilling) but also a delivery issue (more pipeline and storage facilities need to be in place, too). Additionally, they point to the idea of being able to switch fuels (from gas to oil for example) to take advantage of lower prices in one area or another as another viable option to dampen volatility.

The AGA also pointed out that whether storage is considered successful often depends on the market price of gas when the fuel is withdrawn. However, AGA does not feel that price should be the only factor in that equation, nor should it keep storage from being a viable option.

The Merrill Lynch report also called for more storage options in their look ahead for 2004: “Increased price volatility, tight domestic supply conditions, arrival of imports and generally season nature of the gas business in our view make storage an increasingly strategic asset.

“Volatility can mean opportunity for those willing to take risks, and it’s possible that some of the financial players that are stepping into the void left my merchants’ collapse could find merchant storage an attractive investment.”

Additionally, AGA pushed Congress to let the industry explore outside of the box, stating that natural gas “is available from both conventional and unconventional sources in the lower-48 and Canada,” as well as “the deepwater Gulf of Mexico, from Alaska, and from foreign sources via LNG (liquefied natural gas).”

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“This pursuit must be, and can be, environmentally sensitive and it must be aggressive—gas consumers demand and deserve both,” AGA stated.

The report also noted that price volatility is making it difficult to bring in capital. Such uncertainty breeds delays as producers look for the “boom” end of the cycle to invest in projects.

“Such delays in initiating drilling hinder supply, and thus maintain the tight supply/demand balance that puts upward pressure on prices,” AGA stated. “Similarly, uncertainty makes some lenders wary of providing adequate capital for construction of pipelines to transport natural gas from supply areas.”

Crisis and the power plant

According to the AGA, the supply side of the equation cannot possibly keep up with the swings in demand given the current system.

“It often takes one to three years before new natural gas production from existing onshore and shallow offshore fields reaches the market and makes a significant impact on prices,” they stated in “Avoiding the Wild Ride.”

“As a result, very large changes in short-term prices may produce little additional short-term natural gas supply,” they added.

AGA also pointed out that building an Alaskan pipeline or adding extensive delivery infrastructure could take years by themselves, not factoring in “regulatory delay.”

AGA additionally looked at natural gas as the preferred power generation fuel as another large factor in volatility and demand. In fact, they commented that it was “the fastest growing segment of the market and it will continue to provide the greatest increment of gas demand for at least the next decade.”

“When the demand for electricity dictates a need for the plant to operate, electricity prices can rise to justify almost any natural gas price,” the report stated. “At such a time, power generation demand for natural gas does not respond appreciably to gas price signals and natural gas price volatility can increase significantly.”

In fact, the AEO2004, projected that natural gas demand by power generators will increase to 29 percent of total end-use natural gas consumption by 2025; it was 27 percent in 2002 (see Figure 1). The gap between consumption and generation will continue to widen due to more efficient technology, which accounts for that projected generation number being only 2 percent above the status quo.

(Data from EIA’s Form EIA-860 survey, “Annual Electric Generator Report,” show an increase in additions to U.S. electricity generation capacity over the past three years. In 2000, 2001, and 2002 more than 141 GW was constructed, almost all of which runs on natural gas. See Figure 2.)

“Most new electricity generation capacity is expected to be fueled by natural gas, because natural gas-fired generators are projected to have advantages over coal-fired generators that include lower capital costs, higher fuel efficiency, shorter construction lead times, and lower emissions,” the outlook stated. “Toward the end of the forecast, however, when natural gas prices rise substantially, coal-fired power plants are expected to be competitive for new capacity additions.”

In the end, AGA stated that—given all of the factors in play—a tight natural gas market will probably stick around for a few years, especially when paired with the expected 30 to 40 percent increase in consumption over the next 10 to 15 years.

However, as Fritts pointed out to the Senate, these statements do not mean that natural gas is becoming a rare natural commodity.

“We are not running out of natural gas,” he said. “We are running out of places to look for natural gas; we are running out of places where we are allowed to look for gas. The truth that must be confronted now is that, as a matter of policy, this country has chosen not to develop much of its natural gas base. . . .

“If America’s needs for energy are to be met, there is no choice other than for exploration and production [E&P] activity to migrate into new, undeveloped areas,” he continued. “There is no question that the nation’s natural gas resource base is rich and diverse. It is simply a matter of taking E&P activity to the many areas where we know natural gas exists.”

LNG as the holy grail?

It looks like LNG isn’t such a big question mark anymore, as even Spencer Abraham has been discussing ways to expedite the issue (in talks with “state and energy representatives” in L.A. in early March, according to a Dow Jones report).

And, ESAI expects another year of strong LNG imports in 2004.

“Last year, LNG imports totaled 500 billion cubic feet (Bcf), more than double 2002 levels,” stated ESAI energy analyst Scott DePasquale. “We expect total imports to exceed 700 Bcf in 2004, 70 percent of which will be delivered between April and October.”

“The imports will have a landed cost of between $2.50 and $2.75 MMBtu (one million British thermal units), which is extremely competitive with indigenous wellhead prices,” he added.

According to AEO2004’s reference case, total natural gas supplies will grow by 3.5 Tcf from 2002 to 2012 and by 8.7 Tcf from 2002 to 2025. Domestic sources will account for about 57 percent of that, with net imports to cover the remaining 43.

The report sees supplies from overseas sources, “imported through U.S. LNG terminals,” accounting for most of that projected increase in imports.

In “Avoiding the Wild Ride,” AGA lists LNG as one of the options to lower price levels (by helping balance supply) over the next few years.

“The impact of new LNG projects on volatility will depend on how these facilities are operated,” AGA wrote. “Project sponsors would certainly like to see these facilities operate fully 24 hours a day, although seasonal peaking is also a possibility. Thus, these projects will certainly serve to reduce natural gas prices, and they can have a dual benefit in terms of reducing volatility depending on how they are used.”

Fitch Ratings 2004 outlook supported LNG also, finding that, after 2008, “LNG will start to become the marginal supplier of gas to the U.S.”

Even the Merrill Lynch report looking at the year ahead for natural gas listed LNG development as a “supply response” to high prices and increased volatility in the market.

“LNG has returned to the fore as an economically viable means of bridging at least a portion of the supply gap,” the analysts stated. “Look for news about new LNG developments to continue. We are generally positive on LNG, with some caveats.” (Caveats include the idea that, without increased storage, LNG could add to the natural gas market’s price volatility.) The report noted that expansions at each of the four U.S. LNG ports currently in use will bring imports to about 1 Tcf in 2004, with more than 25 other projects in the works in North America.

Twenty-five may seem like overkill, but Cambridge Energy Research Associates’ director of global LNG Michael Stoppard disagrees. In a February 2004 briefing, he stated, “Although an overbuild is possible, it is unlikely to reach the massive proportions of the recent North American overbuild of gas-fired generation because a number of factors will serve to limit development. Indeed, it is also possible these same factors could push facility completion schedules past the 2008 tipping point at which signficiant new LNG flows are needed in North America to balance the rapidly widening natural gas shortfall.”

Some of the factors that Stoppard listed included: “development of expensive liquefaction facilities, sometimes in countries with a history of political instability; ordering and deployment of a sufficient number of tankers for reliable, timely transport; and construction of regasification facilities, potentially in the face of political and public resistence.”

In the written statement to the Senate, AGA suggested the following to help LNG become more viable:

“- Federal and state agencies should review policies that may impede LNG projects.
“- LNG terminals should be encouraged to operate at full capacity as soon as possible.
“- The process of siting LNG offloading terminals should be streamlined.
“- Some facilities should be sited on federal land (to help with permitting).

More information about the AEO2004 can be found at www.eia.doe.gov. The American Gas Association reports can also be found online at www.aga.org.

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