Tuesday, March 27, 2012

Natural Gas Prices: A Shale-shocked Calm?

In 2000, The Economist, noting rising natural gas prices, concluded that “natural gas will be a seller’s market for some time to come”. It was short-lived. Natural gas prices doubled or halved in single 12-month periods at least five times in the decade to 2010. Historically, prices have been much more boring: for nearly seven decades till the lifting of wellhead gas price controls in 1989, they changed, on average, less than 10 percent a year. That changed in the noughties when highly volatile gas prices became the norm. So much so that they claimed several victims: Amaranth Advisors, a hedge fund, closed after losing almost $7 billion betting on rising natural gas prices in one of the largest trading losses; MotherRock, one of the biggest traders of natural gas derivatives on Wall Street, shut down after running up huge losses.

Tamer days may be ahead again. Natural gas prices have exhibited much less volatility since the beginning of 2010. After reaching an all-time high of almost $11 per thousand cubic feet (mcf) in July 2008, wellhead prices fell 72 percent in 14 months to reach $2.98 per mcf in September 2009 and have, more or less, remained there. This week the spot price of natural gas at the Henry Hub was $3.11 per mcf, just 6 percent higher than where it was more than two years ago. A growing supply that is unmatched by demand is the primary reason why prices have not risen to previous levels. But fundamentals suggest that hysteria is unlikely to return to the gas market in the near future.

Domestic production of natural gas has continued to rise despite dramatic drops in wellhead prices and rig counts. This is due in large part to efficiency gains in production from unconventional sources. Maturing of technologies such as hydraulic fracturing and horizontal drilling have enabled vastly higher success rates in extracting natural gas from shale plays and coal-bed deposits. Output from the Barnett shale play, a geological formation in Texas, for example, has exploded from 94 mmcf per day in 1998 to over 4,000 mmcf per day in 2010 as a result of these technologies. Advances in exploration, drilling and production technology, by lowering break-even points, have enabled producers to maintain positive cash flows even as prices have fallen. This is likely to continue as regional unconventional producers, especially those in the Marcellus shale play, which is sold in the Northeast market, receive NYMEX transportation premiums but incur far lower costs. In other words, there appears no reason to believe that U.S. domestic production of natural gas will decline in the near term because of low gas prices.

At the same time, mitigation of surplus natural gas, which must happen before any price rebound, is not likely to find any support from the demand side. Demand for natural gas comprises approximately a quarter of all U.S. energy needs. Power generation and the industrial sector each accounts for about a third of total U.S. natural gas usage. Consumption in the residential and commercial sectors constitutes the remainder. In the near term there will be some growth in demand as reduced industrial output and declining electricity consumption associated with the Great Recession are reversed. Beyond this, any significant further increase in demand must come from natural gas replacing other fuels, primarily coal, in power generation and making inroads into the transportation sector. Neither is likely to generate the kind of demand growth, at least anytime soon, that would lead to extreme volatility returning to gas prices.

Export of surplus gas using LNG terminals could, at least in theory, provide succor to domestic producers. In practice, however, exports face two daunting challenges – a) non-existent infrastructure: there are no existing liquefaction terminals in the lower 48 states (Sabine Pass terminal in Louisiana plans be the first in 2015); and b) unfavorable political calculus: large scale exports could raise U.S. natural gas prices, and therefore electricity rates, by converging domestic and international prices, which are significantly higher.

Natural gas positions held by the non-commercial sector (mostly financial and commodity traders), an indicator of market expectations, seem to confirm this view. Their “net-short” contract positions (excess of open sales- over open purchase- futures contracts) stood at about 170,000 contracts in the last week of October of this year. This implies that the market expects prices to continue to fall somewhat in the near term. When the non-commercial sector feels that natural gas prices are about to rebound, they are likely to liquidate their net-short positions and take profits. While there is no indication yet that this is happening, seasonal increases in demand for natural gas in the coming winter along with partial or full liquidation of net-short positions by traders could produce brief price rallies. Longer-term, however, sector fundamentals point to low and relatively stable equilibrium prices.

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